With the Federal Reserve likely to start hiking interest rates later this year, now can be a good time to take a look at the sectors and the best funds that for performance in a rising interest rate environment.
Here are three sectors or investment types that can do well when the Fed is tightening:
Cyclical stocks tend to perform well in periods of rising interest rates because such periods often coincide with strong economic growth and consumers have a bit more discretionary money to spend.
Financial stocks can be the most direct beneficiaries of rising rates when banks can charge more for lending and thus increase their spread between lending rates and the rates they pay on deposits. Brokerage firms can also benefit when rates are rising because this environment often coincides with periods of market strength and positive investor sentiment.
Floating-rate bonds, also called bank loans, adjust on a regular basis to keep pace with short-term interest rates. That means that when bond yields go up, bank-loan owners receive a higher yield immediately. Therefore, unlike conventional bonds, floating-rate bonds may also appreciate in value during periods of rising interest rates. The only caution is that these bond funds can lose big if the economy turns unexpectedly weak and interest rates turn lower.
With that I give you some of the best funds that invest in cyclicals, financials, and floating rate bonds.
Best Funds for Rising Interest Rates: Consumer Discretionary Select Sector SPDR (XLY)
Consumer Discretionary Select SPDR (ETF) (NYSEARCA:XLY) is a fund with a portfolio consisting of nearly 100% U.S. stocks with concentrated exposure to firms in the S&P 500 index that largely depend on discretionary consumer spending.
This low-cost ETF owns a diverse mix of retail firms, restaurants, media companies, apparel and luxury goods companies, automobile manufacturers and leisure firms.
With 85 holdings (fewer than competing sector funds) the exposure to the top holdings is a bit more concentrated than the average consumer cyclicals fund. Top holdings include Walt Disney Co (NYSE:DIS), Home Depot Inc (NYSE:HD) and McDonald’s Corp (NYSE:MCD).
The 5-year annualized return places XLY comfortably in the top quartile for performance for the 1-, 3- and 5-year returns.
The expense ratio of 0.15% is among the lowest among funds in the consumer cyclicals sector.
Best Funds for Rising Interest Rates: Vanguard Financials ETF (VFH)
An ideal way of getting broad exposure to the financials sector is with a low-cost, diversified index fund like Vanguard Financials ETF (NYSEARCA:VFH).
VFH seeks to track the performance of the MSCI US Investable Market Financials 25/50 Index, which is made up of companies in financial service industries, such as banking, mortgage finance, consumer finance, investment banking, brokerage, insurance and real estate.
Top holdings include Wells Fargo & Co (NYSE:WFC), Berkshire Hathaway Inc (NYSE:BRK.A, NYSE:BRK.B), and JP Morgan Chase (NYSE:JPM).
Index tracking error is tighter with the cheap expense ratio of 0.12% or just $12 for every $10,000 invested.
Best Funds for Rising Interest Rates: T. Rowe Price Floating Rate (PRFRX)
Also called bank loan funds, floating rate bond funds are made for rising interest rate environments and T. Rowe Price Floating Rate (MUTF:PRFRX) is a good choice in the bank loan category.
While not among the top performers in the category since inception in 2011, PRFRX is among the best, low-cost floating rate funds that are accessible to individual investors without out-of-reach investment minimums. The fund is performing in the top half versus the category year-to-date and it outperformed 87% of bank loan category peers in 2014.
PRFRX invests at least 80% of its net assets in floating rate loans and floating rate debt securities. The other 20% may consist of other bond types, including short-term government and commercial debt obligations, investment-grade corporate bonds, mortgage- and asset-backed securities and high-yield corporate bonds.
The floating-rate concentration allows for rates to adjust higher in rising interest rate environments. However, downside risk is significant with potential for greater price declines in falling rate environments than a fund that invests primarily in high-quality bonds or loans.
The yield is an impressive 3.8% and expense ratio is average for the category at 0.85%. The minimum initial investment is $2,500.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
