The Federal Reserve meets again later this month, and there’s a chance they could raise interest rates again.
Since December 2016, the Fed raised interest rates three times, and even if officials decide against raising rates this month, another hike could still come in December if economic conditions warrant. Michael McClain, portfolio manager at Hedeker Wealth, in Lincolnshire, Illinois, says the federal funds futures market is pricing in one rate hike this year and two next year.
“If rates normalize over the medium-term and we get 10-year U.S. Treasury yields back around 4.5 percent … that is going to catch many folks offsides,” he says, noting the current 10-year Treasury yield is around 2.2 percent.
With both the Standard & Poor’s 500 stock index and the 10-year U.S. Treasury markets fully valued, there is significant risk for the markets to weaken, he says.
[See: 10 Skills the Best Investors Have.]
The rate hike could affect some of the sectors that have been the big winners in the past few years. At risk are many of the bond-proxy trades — utilities, high-paying dividend stocks and real estate investment trusts — securities investors previously piled into looking for yield, say market watchers. But like all portfolio holdings, investors need to review why they own these securities as circumstances change.
Debt matters. When the Fed was trying to stimulate the economy with quantitative easing following the 2008 financial crisis, it flooded financial markets with cheap credit, allowing some firms to load up on debt to expand. Now that the Fed is normalizing monetary policy, companies with heavy debt loads could suffer, market watchers say.
That’s a general issue with utilities, telecommunication companies and REITs, says Eric Ervin, chief executive officer of Reality Shares in San Diego.
“As you might expect, these are very, very debt-driven businesses, all three of those,” he says. “And as interest rates rise, it becomes either harder to borrow or just more costly, so their net earnings come down.”
McClain agrees about the headwinds REITs face.
“In a rising-rate environment, REITs often underperform as future cashflows are discounted at higher interest rates, depressing valuations,” McClain says.
The effects of interest-rate creep are likely being felt REITs and telecoms, as seen in the returns of a few top exchange-traded funds focused on those investments. The $34 billion Vanguard REIT ETF (ticker: VNQ) is up 3.55 percent on the year, underperforming the SPDR S&P 500 ETF Trust ( SPY) return of 12 percent, while the $1.3 billion Vanguard Telecommunications Services ETF ( VOX) is down 5.03 percent. Only the utilities sector is holding strong still, as seen by the Utilities Select Sector SPDR Fund ( XLU), up 15 percent this year.
Eric Mattinson, an investment advisor representative at Semmax Financial Group in Winston-Salem, North Carolina, agrees debt is going to matter when looking at companies. Companies with low debt are considered higher-quality companies and will likely do better in a rising-rate environment.
“A lot of these utilities have kind of shored up their financials while the rates were low,” he says. “They restructured or reorganize their debt to get it at a much lower rate for a longer period of time. And so that’s kind of set themselves up to be able to weather some of these headwinds with the rising rates.”
[See: 9 Ways to Buy Stocks That Everyone Needs.]
Two utilities he likes are Duke Energy Corp. (NYSE: DUK), which the firm owns, and Dominion Energy ( D), which it does not own. These utilities have low debt loads.
“Cash is king when you are paying a dividend and rising rates will impact the cash flow as well,” he says.
Utilities may be better positioned in this environment than some people think, he adds. During the most recent rate tightening cycle from 2004 to 2007, when interest rates rose from roughly 1 percent to slightly more than 5 percent, the utilities sector outperformed S&P 500 for each of those years, he says.
“It’s not necessarily an absolute that the sector as a whole is going to perform poorly,” he says.
Positioning for higher rates. McClain says although the U.S. has been in a low-rate environment, rates could start to revert to average eventually. He notes over the past 50 years, the average yield on the 10-year U.S. Treasury note is 6.25 percent, so a return to 4.25 percent shouldn’t be surprising.
He says investors concerned about rising rates need to look at the bond market for signals. The bond market will react to any changes in monetary policy by global central banks and inflation, two important influences now.
Meanwhile, investors should review their portfolios, Mattinson says.
“I wouldn’t say we’re right about to put our life preserver on and jump ship,” he says. “But there are some ships that I’d much rather be sailing than others.”
Even though rates are rising, he says dividend-paying companies can still be good holdings, especially for investors looking to add to their portfolios. Mattinson says it comes back to looking at quality companies with low debt, good cash flow to pay dividends and a history of paying dividends during all market cycles.
McClain says yield-hungry investors could also look to convertible bonds, which are debt investments that are convertible into stock.
[See: 7 Stocks That Could Save Your Portfolio.]
“We like convertible bonds here because historically periods of rising interest rates are positive for stocks and risk assets,” he says. “With a convertible bond, the stock-like sensitivity of the bond can appreciate even with interest rates increasing.”
More from U.S. News
The Top 10 Investment Portfolio for Millennials
6 Things to Know About Mark Zuckerberg’s Manifesto
20 Awesome Dividend Stocks for Guaranteed Income
These Sectors Will Feel the Sting of Rising Rates originally appeared on usnews.com
