Increased rates and borrowing costs aren’t bad for all ETFs.
In early 2020, before the disruptions caused by the pandemic, interest rates on the all-important 10-year U.S. Treasury bond had edged up briefly to top 1.9%. But as the severity of COVID-19 became clear, rates on this closely watched bond plunged to a 10-year low of under 0.32%. As the global economy moves past the pandemic, yields on 10-year bonds have returned to above 1.6% — and many market watchers say they’ll go even higher in the months ahead, with rates on everything from mortgages to credit cards to business loans increasing in kind. If this occurs, a rising rate environment can cause big disruptions across various asset classes. So how can you prepare your portfolio for this shift? Here are seven potential options that might be a good fit, depending on your financial goals.
Financial Select Sector SPDR Fund (ticker: XLF)
It makes sense to start with XLF, the largest financial sector exchange-traded fund out there with more than $45 billion in assets. Top holdings include Warren Buffett’s investment giant Berkshire Hathaway Inc. (BRK.A, BRK.B) and banking giant JPMorgan Chase & Co. (JPM), to name a few. The reason financial firms like these are a good play in a rising interest rate environment is because these firms tend to increase the rates they charge for loans they extend to others. And at the same time, many of these firms have borrowed capital at a lower rate based on the market conditions in prior years. That creates a natural tailwind for any of the core financial activities at these companies — as evidenced by the fact that XLF has risen more than 37% so far this year, compared with just 23% for the broader S&P 500 in the same period.
SPDR S&P Regional Banking ETF (KRE)
A slightly smaller banking ETF, this fund is focused only on regional U.S. financial firms. Top holdings include stocks such as SVB Financial Group (SIVB) and KeyCorp (KEY) as opposed to the big dogs in XLF. The reason this may be an appealing alternative is because these kinds of institutions are almost exclusively involved with borrowing and lending businesses, which isn’t always the case at big Wall Street titans like JPMorgan. This focus works well, with KRE tacking on 36% year to date to keep up with XLF. It’s also worth noting that while this regional banking ETF is a bit more focused, it’s still very popular and liquid with some $5 billion in assets under management.
iShares Floating Rate Bond ETF (FLOT)
Looking beyond equity markets, bond funds offer a host of alternatives when it comes to investing during a rising interest rate environment. One of the most intuitive ETFs out there that you can invest in right now is FLOT, a fund that is made up of bonds that adjust their rates higher in real time as interest rates rise. Consumer-focused loans like variable rate mortgages or credit card plans can all see their rates move higher in this kind of environment, and FLOT allows you to hold a portfolio of floating rate bonds issued to top-rated corporations such as Goldman Sachs Group Inc. (GS) and Verizon Communications Inc. (VZ) as well as institutions such as the European Investment Bank. Admittedly, the trailing yield of this ETF is only 0.5% at present, but as rates in the broader marketplace rise, the bonds that make up this fund will begin to command higher yields over time.
Fidelity Low Duration Bond Factor ETF (FLDR)
A more defensive way to navigate a rising interest rate environment is to rely on bonds that have a lower duration — which is a measure of the time it would take for an investor to recoup their original investment and is closely related to the bond’s time to maturity and is sensitive to interest rates. As interest rates rise, newer bonds are naturally more attractive thanks to better yields — and older bonds are “discounted” as a result and lose value. Bonds that are closer to their time to maturity carry less risk of interest rate increases. With a very short-term time horizon in its holdings, and with an average duration of less than a year in its current lineup of about 250 positions, FLDR doesn’t have to worry as much about this trend as the bonds often mature very quickly. They are also low-risk investments in top corporations or the U.S. Treasury market, adding to the stability here. The yield admittedly isn’t very high at just 0.5% or so, but the purpose of FLDR is more as a rock-solid foundational investment than a growth option. And besides, a rising rate environment could lift this yield slightly over time.
WisdomTree Interest Rate Hedged U.S. Aggregate Bond Fund (AGZD)
As the name implies, this WisdomTree ETF is hedged against any decline in bond values as rates rise. It does so by actually betting against bonds via short positions in U.S. Treasurys. But don’t think this is one of those super aggressive inverse funds designed to go up when a certain asset class goes down. There’s assuredly risk here, but the lion’s share of the portfolio is invested in more than 2,000 individual bonds, from top-rated corporation and government debt to higher-risk junk bonds. The short positions are simply designed to smooth out the ride in this fund, which offers a diversified mix of bonds and a decent yield of about 1.8% — significantly higher than other funds on this list. It also has been rock solid in 2021, down less than 1% on the year despite an admittedly volatile market for bonds.
Simplify Interest Rate Hedge ETF (PFIX)
In contrast to AGZD, this tactical ETF from smaller asset shop Simplify holds a large position in interest rate options with the goal of providing direct exposure to large upward moves in interest rates. The bad news, of course, is that when rates decline PFIX can take a significant tumble. Consider that, after a run-up in rates earlier this year, PFIX has actually declined more than 15% since May as the interest rate environment has been choppy. Still, the fund is liquid and established with more than $100 million in assets and could be a good bet if you think low interest rates are a thing of the past — and significant moves higher in rates are likely in the near term. Just remember this is a tactical position for aggressive and active traders, not the buy and hold crowd.
Schwab U.S. TIPS ETF (SCHP)
The final option on this list is less about a direct play on rising rates but rather a strategy to invest based on the root cause: inflation. The Federal Reserve typically raises benchmark interest rates specifically to keep a lid on rising prices, and while there isn’t a one-to-one correlation, it is generally typical that any rise in interest rates comes alongside inflationary pressures. So in such an environment, Treasury inflation-protected securities — or TIPS for short — could be worth a look. This special class of Treasury bond has a principal value benchmarked to the widely watched consumer price index. That means if and when consumer prices rise — and perhaps interest rates with them — SCHP’s portfolio rises in value, too.
ETFs for rising interest rates:
— Financial Select Sector SPDR Fund (XLF)
— SPDR S&P Regional Banking ETF (KRE)
— iShares Floating Rate Bond ETF (FLOT)
— Fidelity Low Duration Bond Factor ETF (FLDR)
— WisdomTree Interest Rate Hedged U.S. Aggregate Bond Fund (AGZD)
— Simplify Interest Rate Hedge ETF (PFIX)
— Schwab U.S. TIPS ETF (SCHP)
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7 ETFs for Rising Interest Rates originally appeared on usnews.com
Update 10/27/21: This story was published at an earlier date and has been updated with new information.
