ETFs To Play In A Rising Rate Environment

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September 9, 2013 4:31pm NYSE:BKLN NYSE:BSV

percent rateNeena Mishra: A slew of positive economic data in the last few days has led many market participants to believe that the Fed will start tapering this month. On the other hand, some analysts still think that there are a number of factors that support

the case for continuation in QE at current levels.

While no one can actually predict whether they will or they will not decide on tapering in the upcoming meeting, it appears that the market has already priced in some tapering—about $10 to $15 billion cut in the $85 billion monthly purchases. The actual timing is somewhat irrelevant now—it may start in September, December or early next year. (Read: 3 Cyclical ETFs for an Improving Economy)

In anticipation of tapering, interest rates have moved up significantly, the 10-year Treasury note yield touched 3% yesterday—the highest since July 2011 and a sharp move from 1.6% seen earlier this year. Rising rates have resulted in increasing losses for bonds.

Bond Bear Market is Here; Realign Your Portfolio

Considering that yields have surged too much, too soon, there is a chance that they may come down slightly before going up again and it is also likely that the next move up will not be as steep as the current one. But one thing is absolutely clear—the 30 year bull run in bonds is over. (Read: 3 Excellent ETFs for Dividend Growth)

Going by the performance of Barclays U.S. Aggregate Index, bond market is on track to deliver its worst performance this year, since 1994. It is not surprising that bond ETFs have seen massive outflows in the past few months.

Investors seeking to have some exposure to bonds could consider short-term bond funds, as the Fed has made it clear that short-term rates will continue at near-zero levels for a long time. Some of the popular ultrashort bond ETFs like Vanguard Short-Term Bond ETF (BSV) have seen increased inflows of late.

Many investors have invested in floating rate loans funds as these ETFs enable investors to earn a decent return, while reducing the credit risk (being secured by liens on company assets) and withstand rising interest rates without losing value (being floating rate assets).

PowerShares Senior Loan ETF (BKLN) has been one of the top asset gatherers among ETFs—with a $3.9 billion asset gain this year. The product has not disappointed its investors; it has returned 2.2% year-to-date, while yielding an attractive 4.7%.

Considering that corporate profits have been on the decline while corporate leverage is now back to pre-crisis levels, investors may like to keep an eye on their investments even though there are no apparent warning signs in the space as of now. Companies below investment grade ratings had $2 trillion of junk bonds and leveraged loans outstanding in July, and will need to refinance those at higher rates as rates rise.

Inverse bond ETFs like ProShares Ultrashort 20+ Year Treasury ETF (TBT) are also becoming increasing popular with investors as they provide an opportunity to profit from rising interest rates. However investors need to remember that they are powerful but complex tools and are not meant for long-term buy and hold investors.

Rising Rates = An Improving Economy; Invest in Cyclical Sectors

Many investors fear that rising rates will kill the stock market rally, but the fact is that the increase in rates reflects an improving economy and lower risk of deflation—which are positive for stocks. While economy is certainly not going to start growing at breakneck speed anytime in near future, the overall economic picture continues to brighten slowly.

Increase in interest rates are bad for stocks only when the central bank raises them to combat inflation, which is not going to be the case anytime in the near future.

There are some sectors that will benefit more in the improving economic environment and this may be right time for investors to start repositioning their portfolio with higher allocation to some of the cyclical sectors like technology, industrials and energy that have a better earnings growth outlook for 2014, compared to the current year.

Some of the ETFs from these sectors like Industrial Select Sector SPDR (XLI), Vanguard Information Technology ETF (VGT) are worth considering.  If the labor and housing markets continue to recover, consumer discretionary and retail sectors may also continue their outperformance. (Read:3 Top Ranked Consumer ETFs to buy now)

Regional banks benefit in the current environment of rising longer-term rates and steepening yield curve. Investors could look at SPDR S&P Regional Banking ETF (KRE).

This article is brought to you courtesy of Neena Mishra From Zacks.

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