The positive impact of a rate hike
Banks (WFC) (XLF) tend to benefit most from rising interest rates. Banks make their profits from the spread between how much they pay to borrow money and how much interest they can collect when they lend the money to customers. As rates rise, this spread tends to widen. For example, Bank of America (BAC) projected that its net interest income could grow by as much as $3.9 billion over the next 12 months as interest rates normalize.
Insurance companies (KIE) (CB) generally don’t make much of a profit from premiums, but they invest premiums to generate profits. Since insurance companies are highly dependent on their ability to generate interest income (most insurance companies’ investments are fixed-income), rising rates can significantly boost profits.
The above table shows the correlation between various funds and the S&P 500. The higher the correlation, the greater the impact of a rate hike.
Technology companies (IYW) usually don’t carry much debt, and even if they have issued debt, it’s only to take advantage of low interest rates. This is especially true of the larger, established dividend-paying tech companies. For example, Apple (AAPL) has more than $47 billion in long-term debt on its balance sheet, but it issued its debt to take advantage of record-low interest rates, not because its business depends on borrowed money.
Central banks will tighten monetary policy only when the economy gains momentum. Thus, tech companies stand to benefit from higher sales as the economy improves because consumers have higher disposable income and buy more tech gadgets such as smartphones and laptops.
The negative impact of a rate hike
REITs (NLY) (IYR) (REM) perform poorly as rates rise. These companies rely heavily on borrowed money and could see profit margins contract or even become negative if rates increase. Equity REITs (those that own properties) also borrow money and could be hurt by rising borrowing costs. Many equity REITs maintain relatively low debt levels, but they could face selling pressure if income seekers flee to safer fixed-income assets.
Utilities (XLU) (WTR) (STR) also tend to carry a lot of debt, which can lead to contracting profit margins if rates rise. Moreover, utilities generally don’t produce much growth and pay out most of their earnings as dividends. In other words, these relatively high dividends are more like bonds as they provide a steady source of income to investors. If bond yields rise to a comparable level, utilities seem to be less attractive.
In the next article in this series, we’ll shed some light on how investors can gain exposure to high-dividend yield stocks.