The Federal Reserve of the United States has been practicing rock-bottom interest rate policies from last year in the wake of the pandemic. The Fed also has a QE (quantitative easing) in place. However, in the past one year, the U.S. economy has advanced a lot leaving behind the pandemic-induced slump.
The U.S. economy grew an annualized 6.4% in the first quarter of 2021, breezing past expectations of 6.1%, following a 4.3% uptick in the previous three-month period. Apart from the reopening-driven third-quarter jump last year, the latest reading marked the best period for GDP since the third quarter of 2003 (read: ETF Areas to Win on Smashing Q1 U.S. GDP Growth).
This gives cues of a potential rise in inflation and rates. On May 4, Treasury Secretary Janet Yellen indicated that interest rates may need to rise over time to keep the U.S. economy from overheating. However, Yellen elucidated her remarks later on, saying higher rates are “not something I’m predicting or recommending” as quoted on Financial Times.
On May 4, Yellen also told in a Wall Street Journal CEO Council event that she does not see inflation as a problem for the U.S. economy and that any price increase would be fleeting because of supply chain issues and the recoil in oil prices to the pre-pandemic levels, as quoted on Reuters.
We believe that if the U.S. economy continues to expand steadily and the COVID-19 scare settles down, a modest rise in interest rates would be likely. If this happens, below are the ETF areas that should be played.
Financials – First Trust NASDAQ ABA Community Bank Index Fund (QABA)
Banks will benefit from the jump in long-term interest rates. As banks seek to borrow money at short-term rates and lend at long-term rates, a steepening yield curve earns more on lending and pays less on deposits, thereby leading to a wider spread. This expands net margins and increases banks’ profits.
Materials – SPDR S&P Metals & Mining ETF (XME)
Commodity prices have been on the rise lately on expectations of beefed-up global growth. A softer greenback has also been driving materials and commodity prices. Most commodities ranging from industrial metals to agricultural products have been staging a rally. So, rising rates are not a worry for this sector as manufacturers will charge higher for their production.
Value Stocks – Vanguard Value ETF VTV
Rising rates are good for value stocks than growth ones as the latter’s cash flows come way out in the future. Thus this group seems less valuable in a rising rate scenario as indicated by New York University finance professor Aswath Damodaran, as quoted on CNBC.The fund VTV yields 2.17% annually and charges 4 bps in fees.
Floating Rate Bonds – iShares Floating Rate Bond ETF (FLOT)
Floating rate notes are investment grade bonds that do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of issuers.
Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates compared to the traditional bonds. FLOT has an effective duration of 0.12 years and thus presents minimal interest rate risks (see all Investment Grade Corporate Bond ETFs here).
Senior Loan – Highland/iBoxx Senior Loan ETF (SNLN)
Senior loans are issued by companies with below investment grade credit ratings. In order to make up for this high risk, senior loans normally have higher yields. Since these securities are senior to other forms of debt or equity, they give protection to investors in any event of liquidation. As a result, default risk is low for such bonds, even after belonging to the junk bond space.
Senior loans are floating rate instruments and provide protection from rising interest rates. In a nutshell, a relatively high-yield opportunity coupled with protection from the looming rise in interest rates should help the fund to perform better in 2021. SNLN could thus be a good pick for the upcoming days. It yields around 2.42% annually.
Short-Term Bonds – Vanguard ShortTerm Bond ETF BSV
Higher rates might lead to huge losses for investors who do not hold bonds until maturity. As a result, a short-duration bond ETF like BSV acts as a better hedge to rising rates. It charges 5 bps in annual fees and yields 1.54% annually.
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VIPERS-VALUE (VTV): ETF Research Reports
ISHARS-FL RT BD (FLOT): ETF Research Reports
SPDR-SP MET&MIN (XME): ETF Research Reports
HILND/IBX-SR LN (SNLN): ETF Research Reports
FT-NDQ ABA CBIF (QABA): ETF Research Reports
VANGD-SHT TRM B (BSV): ETF Research Reports
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