With signs that ultra-low interest rates could be history, investors may want to tweak their portfolios to profit from this trend.
The U.S. Federal Reserve Board is expected to hike interest rates again before year end after two increases in 2017. The Bank of Canada also raised its key rate twice this year with a third move possible in the near term. Even the Bank of England is making noises about borrowing costs rising.
Bank and insurance stocks are among the securities poised to gain altitude in the new monetary era. Because exchange-traded funds [ETFs] are an easy way to play rising rates, we asked two analysts for their top picks in this space.
Daniel Straus, ETF analyst at National Bank Financial Inc., Toronto
The pick: SPDR S&P Regional Banking ETF
Management expense ratio [MER]: 0.35 per cent
This ETF invests in U.S. regional banks whose shares should benefit more from rising rates than their larger peers, says Mr. Straus. "Banks traditionally derive their business from playing the spread in interest rates between short-term deposits and long-term loans," he said. "If rates increase and the yield curve steepens, this should allow more traditional banks to grow revenues."
Rate hikes help the smaller banks boost profit because they tend to focus on loans and deposits, while the big banks also get revenue from sources that include investment banking and trading.
This ETF has a smaller-cap bias because it holds about 100 U.S. banks equally, he said. Smaller names have more upside than larger firms in a rising market, but more downside in a falling market, he noted.
The pick: BMO Laddered Preferred Share ETF
MER: 0.50 per cent
This ETF, which invests in rate-reset preferred shares, should do well in a rising rate environment, says Mr. Straus. The dividends on these investments adjust every five years to a yield that is linked to the five-year Government of Canada bond.
When the Bank of Canada cut rates in 2015 in response to the oil crash, however, this ETF suffered losses that year. With rates set to rise, "investors can look to rate-reset preferred shares to increase payouts," he said.
This large and easily tradeable ETF is attractive for investors who want to take a more tactical approach to these securities, he said. Due to the complexity of the preferred-share market, others may prefer an actively managed fund, such as the RBC Canadian Preferred Share or Horizons Active Preferred Share ETFs, he said.
The pick: WisdomTree Negative Duration High Yield Bond ETF
MER: 0.48 per cent
This ETF can benefit from rising interest rates from using a long-short bond investment strategy, says Mr. Straus. This fund tracks the performance of a long position in U.S. high yield bonds – which is non-investment grade debt – and an aggressive short position in U.S. Treasury futures.
That effectively brings "its total duration [sensitivity to a change in interest rates] exposure into negative territory," he said. "If interest rates start to rise, HYND will actually increase in value, while other high-yield bond ETFs with similar credit exposure will decline," he noted.
The risks to this ETF include a sudden decline in interest rates, or ongoing costs associated with the short position that could erode returns should rates stay flat for a protracted time period, he said.
Denise Davids, ETF and mutual fund analyst at Industrial Alliance Securities Inc., Toronto
The pick: Hamilton Capital Global Bank ETF
MER: 1 per cent
This actively managed global bank ETF, which holds 57 stocks, is a diversified play on rising interest rates, says Ms. Davids. Half of the portfolio is in North American names, including 34 per cent in U.S. mid-cap banks.
"Outside of North America, Northern Europe and Australia are particularly attractive, as these regions have some of the best capitalized banks in the world," she said. While rates have risen in North America, this is not the case globally, she noted.
The ETF's manager Hamilton Capital Partners, however, keeps an eye on other central banks for opportunities amid various macro-economic factors, she added. Slower-than-expected rate hikes is a risk to this ETF, as well as the potential inability of U.S. Congress to pass corporate tax cuts that are expected to boost bank profits further, she said.
The pick: iShares S&P/TSX Capped Financials ETF
MER: 0.61 per cent
Rising rates should provide momentum for this ETF focused on the Canadian financial sector, says Ms. Davids. Bank stocks, which make up about 70 per cent of this fund, tend to do well when the economy is improving, and profit margins are higher due to climbing interest rates, she said.
The ETF also holds insurance companies, which invest their premiums into bonds. The coupons on these fixed-income securities increase as rates rise, and that increases the insurers' investment income, she said.
A major slowdown in loan growth could negatively impact this ETF, as well a higher-degree of regulation placed on Canadian banks, which are "more lightly regulated" compared with some of their global peers, she said. A sudden increase in claims is also a risk to shares of insurers, she added.
The pick: Dynamic iShares Active Preferred Share ETF
MER: Not finalized. Management fee is 0.58 per cent.
This actively managed ETF is largely invested in rate-reset preferred shares whose payouts can increase when interest rates rise, says Ms. Davids. Their dividends are linked to the five-year Government of Canada bond yield plus a premium, she said.
"If this underlying yield increases, the dividends on the preferred share resets also increase." Key to this ETF is the fact that it is overseen by a team led by veteran portfolio manager Marc-André Gaudreau of 1832 Asset Management LP. Active managers can exploit opportunities in a market where securities can be mispriced or hard to sell, she said.
This fund holds the iShares S&P/TSX Canadian Preferred Share ETF and preferred shares of mainly Canadian businesses. A recession or declining economy would negatively impact this ETF, she noted.