Ten-year Treasury yields are ebbing a bit Tuesday, but those yields are up 23% since Feb. 2. Couple that yield spike with $6.4 billion in outflows from fixed income exchange traded funds just this month, and it is evident some investors are preparing for the Federal Reserve to raise interest rates sooner than later.
Historically, Fed tightening cycles have crimped returns for some sectors, but higher rates do not mean investors should forsake equities altogether. Not surprisingly, telecom and utilities stocks with a highly negative correlation to interest rates. [Winning Sector ETFs for Rising Rates]
“While investors can look to short duration exposures, such as floating rate notes and senior loans, investors should not ignore opportunities in US equities at the sector and industry level,” said State Street Global Advisors Head of Research David Mazza in an email exchange with ETF Trends. “Investors can focus on three areas to help them including positive sensitivity to the US 10-year Treasury Yield, low debt to capital ratios, and cyclicals over defensives.”
Not surprisingly, highly leveraged sectors have a tendency to underperform when interest rates. Conversely, sectors that are home to companies with pristine balance sheets and large cash reserves can prove durable as the Fed turns hawkish.
The vulnerability of the utilities sector to higher rates was on display in 2013. As 10-year yields surged, the Utilities Select Sector SPDR (NYSEArca: XLU) rose just 13% compared to a 32.3% gain for the S&P 500.
“High levels of debt to capital (leverage) can slow cash flow when financing costs are increasing and debt is needed for finance continuing operations,” notes Mazza.
Investors looking for ETFs with deep exposure to lightly leveraged firms can turn to the SPDR Morgan Stanley Technology ETF (NYSEArca: MTK) and the SPDR S&P Semiconductor ETF (NYSEArca: XSD), among others.
MTK tracks the Morgan Stanley Technology Index, which is currently a mixture of “old school” and new technology companies. While the equal-weight MTK features Amazon (NasdaqGS: AMZN), Netflix (NasdaqGS: NFLX) and LinkedIn (NYSE: LNKD) among its top 10 holdings, Apple(NasdaqGS: AAPL) and Google (NasdaqGS: GOOGL) combine for over 9% of the ETF’s weight.
Apple, Cisco (NasdaqGS: CSCO), Microsoft (NasdaqGS: MSFT) and Google, a combined 14.3% of MTK’s weight, have over $345 billion in cash combined, underscoring MTK’s utility as ideal sector ETF with which to endure rising rates.
XSD, the equal-weight semiconductor ETF, has its own advantages applicable to rising rates environments. For example, the ETF does have exposure cash-rich large-cap chipmakers, several of which have been recent dividend growers. Dividend growth stocks are, historically, excellent rising rates and inflation fighters. [Dividend ETFs for Rising Rates Protection]
With its recent dividend increase, Qualcomm (NasdaqGS: QCOM) has more than doubled its quarterly dividend in just three years. Broadcom’s (NasdaqGS: BRCM) payout is up 40% in three years. Texas Instruments (NasdaqGS: TXN) has doubled its payout in three years. Broadcom and Texas Instruments combine for 4.7% of XSD’s weight.
When rates surged in 2013, XSD climbed 34.1%, more than double the returns offered by XLU.
“The impetus for an increase in rates is due to a strengthening economy and as one would expect in an economic expansion cyclicals should out pace defensives as the economy picks up steam,” said Mazza.
SPDR Morgan Stanley Technology ETF
Tom Lydon’s clients own shares of Apple and Cisco.