With a recent spike in borrowing costs causing swings in the market and angst on Wall Street, now might be a good time for investors to consider rejiggering their portfolios and shifting toward investments that fare better when interest rates are rising.
A market-moving shift appears to be underway. The long period of historically low rates in place since the 2008 financial crisis – which enabled homebuyers to get cheap mortgages, car shoppers to obtain 0-percent loans and corporations to grow their businesses and profits with the help of cheap money – is reversing as investors and the Federal Reserve, reacting to an improving U.S. economy, push borrowing costs back toward more normal levels.
The Fed has hiked short-term rates three times this year, raising its key rate – which it slashed to zero in 2008 – to a range of 2 percent to 2.25 percent. Adding to investors' concern is the recent rise in the yield on the 10-year Treasury note to above 3.25 percent, a seven-year high.
Investors fear that higher rates will slow the economy and dent corporate profits. Those potential obstacles have caused increased market volatility on Wall Street in the past three trading sessions, with the Dow Jones industrial tumbling more than 340 points. It has also changed the outlook for many types of investments, ranging from stocks to bonds to real estate.
As a result, "portfolios need to shift" to respond to the changing risk and reward profile of different investments, Michael Wilson, equity strategist at Morgan Stanley, wrote in a research report.
Despite conventional thinking that rising rates are bad for stocks, historical data show that the broad Standard & Poor's 500 stock index has actually posted strong returns. Stocks moved higher in 12 of the 15 periods since 1950 when the 10-year Treasury yield was rising, or 80 percent of the time, according to data from SunTrust Advisory Services. In fact, the S&P 500 posted average annualized returns of 12.6 percent during those 15 periods.
"This makes sense as higher rates tend to coincide with an expanding economy," says Keith Lerner, chief market strategist at SunTrust Advisory Services.
Trying to pinpoint how high the yield on the 10-year note must climb before it becomes a major hindrance for the stock market is tough to decipher.
Credit Suisse's chief U.S. equity strategist Jonathan Golub cites 3.5 percent as a threshold to watch, while Lindsey Bell of Wall Street research firm CFRA cites 4 percent and Bank of America Merrill Lynch says it would have to jump to 5 percent before bonds would look more attractive than stocks.
But not every investment fares well when borrowing costs are going up. Here's a basic game plan, based on past history, on what to own and what to avoid when interest rates are rising:
Stocks to buy ... and avoid
The best companies whose stocks you should own when borrowing costs are rising are those without a lot of debt and plenty of cash on hand, says Brian Belski, chief investment strategist at BMO Capital Markets.
His firm cited a list of stocks that fit this profile, including A.O. Smith, which makes water heaters; video game maker Electronic Arts; health insurer Humana; and semiconductor giant Intel.
Some segments of the stock market fare better than others when the 10-year U.S. government bond is moving higher. The top performers going back to 1970 are tech stocks, energy shares, companies that sell discretionary goods to consumers and big industrial companies, according to data from CFRA Research.
What sectors to favor depends, in part, on why borrowing costs are becoming more expensive, says Brad McMillan, chief investment officer at Commonwealth Financial Network.
"When rates are rising because of faster growth, you want to be overweight sectors that benefit from that growth, like financials or technology," McMillan explains. "When rates are rising because inflation is rising, you want to be exposed to sectors that trade in things that will be affected by inflation – such as energy."
Banks are also viewed as a good place to park cash when rates are rising, according to Belski.
Financial institutions that lend money benefit when the economy is strong and people have jobs and income to pay back their loans. Banks also benefit from rising rates as the spread widens between the rate they earn on loans versus the interest they pay to depositors.
The parts of the market that normally feel the most pain when rates are rising are those that investors seek out for income and which pay out sizable dividends, such as utilities, real estate and telecom, says McMillan.
These interest rate-sensitive stocks are known as "bond proxies." Real estate companies in the S&P 500 now yield 3.58 percent, while utilities are yielding close to 3.5 percent, data from S&P Dow Jones Indices show. The interest payout on the 10-year Treasury is approaching those levels.
"(These stocks) tend to become less attractive relative to bonds – the other income investment – as rates rise, so should be avoided," McMillan advises.
Homebuilders and auto companies can also come under pressure, as sales of homes and cars, trucks and SUVs could stall due to higher financing costs. "Affordability becomes worse as rates go higher," says Lerner.
Bond strategies to consider
The bad news for current bond holders is that when yields rise, the price of the underlying bond falls. But the good news is that rising income payments from the higher-yielding bonds over time will more than offset the loss of principal and leave investors with a positive total return, a BlackRock analysis of the last rising rates cycle from 2003 to 2006 found.
Buying bonds with shorter maturities can also reduce the potential for losses when rates rise, adds SunTrust's Lerner. The reason: the more quickly your bond matures – and the issuer pays your principal back – the faster you can reinvest the money into a new, higher-yielding bond.
"If you buy a 10-year bond at 2 percent and the yield quickly jumps to 3 percent, 10 years is a long time to earn a lower yield," Lerner explains. In contrast, a 2-year Treasury bond now yields close to 2.9 percent, which not only delivers a comparable return but can be reinvested in 24 months at a better rate if rates continue to rise.
Investors putting money in the bond market will benefit from the higher yields. The current 3.25 percent yield on the 10-year Treasury, for example, offers a far better risk-free return than it did back in October 2016, when the yield was closer to 1.75 percent.
Real estate pain
Rising interest rates mean more expensive mortgages, which crimps affordability for prospective homebuyers. And if fewer people can afford homes, that also could cause real estate prices to stagnate or even fall, crimping the build up in equity of current homeowners, analysts say.
"Real estate is one sector that tends to perform (worse) when rates begin to rise," says CFRA's Bell.