ETF Trends
ETF Trends

By Ryan Gilmer, CFA – VP Investment Management – TOPS ETF Portfolios

Most investors are familiar with the inverse relationship interest rates have on bond returns. As interest rates rise, bond prices fall and vice versa. However, rate changes can also impact equity returns.

While persistent periods of low interest rates affect corporate borrowing and profitability for nearly all stocks, there are three sectors which have been affected to a greater degree by the medium-term interest rate environment as well as the shorter-term environment in the days following the election: real estate, utilities and financials.

Financial Impact

There is straightforward rationale for rates affecting these sectors to a greater degree. Borrowing, lending and the yield tradeoff are all areas of significant financial impact.

By regulation, REITs are forced to return 90% of their taxable income to their investors each year. This means as interest rates rise, REITs may face increased borrowing costs which affects their financial position. It also means other income oriented investments become more competitive. Both factors can cause REITs face pricing pressure as rates increase.

Similarly, many investors are attracted to utility stocks due to their defensive nature and above average dividends. Much like REITs, utilities become less competitive with other income investments (such as traditional fixed income or high yield bonds) as rates rise. Many utilities are also involved in capital intensive businesses, which means higher than average debt levels and consistent demand for borrowing. It’s easy to see how higher rates could be negative given these circumstances.

Financial stocks, on the other hand, are poised to benefit from a higher rate environment. When banks can lend at higher rates, they tend to be more profitable and make a higher spread between what they pay depositors and what they charge to lend.  Rates tend to rise during periods of economic growth, which increases loan volume.  Making more loans at better spreads is a strong driver for bank stocks.

Rising rates also affect insurance companies. When they write policies, proceeds from premiums are invested in bonds. As rates rise, this produces more income. It also affects the guarantees companies can make on annuity products.  During periods of falling interest rates, it becomes more difficult for insurance companies to make enough on their investments to meet guarantees made in higher rate environments. This is negative for profitability and will reverse over time during a period of rising rates.

The ETF Effects

The following graph shows a Bloomberg 3-year correlation matrix of several interest rate sensitive ETFs and the indices they track.  In bold are the correlations to the ICE U.S. Treasury 7-10 year Index TR (IEF):

Index CodeIndex NameTracked by
 IXUNTRUtilities Select Sector Index TRUtilities Select Sector SPDR (XLU)
 DWRTFTDow Jones US Select REIT Total Return Index TRSPDR Dow Jones REIT (RWR)
 IXMTRFinancial Select Sector Index TRFinancials Select Sector SPDR (XLF)
 IDCOT7ICE U.S. Treasury 7-10 Year Index TRiShares 7-10 year Treasury Bond (IEF)


S&P 500SPXT0.1840.4540.851-0.2681

Source: Bloomberg

Correlation means that two variables have a mutual relationship. A correlation of -1 means that for every unit move in X, Y moves in the opposite direction (negative correlation).  A correlation of 1 means that for every unit move in X, Y moves in the same direction (positive correlation).  A correlation of zero indicates that the two variables have no relationship to each other.

As we can see from the matrix, each of the sector funds listed has a more meaningful correlation than the market at large.  In the case of REITs and utilities, there is a positive correlation.  This indicates that lower interest rates, which are positive for treasury bonds, are also positive for these sectors.  In the case of financials, the opposite is true.  Lower interest rates have been negative for financials.

Next, consider the chart of 1yr performance of the same sectors:


The yellow line shows the performance of the index tracked by IEF.  From November of 2015 through June of 2016, rates fell, IEF’s index rose, and utilities and real estate outperformed while financials lagged.  As rates bottomed near the end of June, performance reversed.  Financials have come roaring back, especially in the aftermath of the Trump victory, while utilities and real estate have underperformed.

While the rate movements of 2017 are unknown today, it’s quite possible the performance of these three sectors will be tied to interest rate trends.  Investors considering an overweight or underweight should consider the implications that interest rates will have on performance.

Ryan Gilmer, CFA, is VP Investment Management at TOPS/ValMark Advisers, a participant in the ETF Strategist Channel.

Important Disclosure

RWR, XLU, XLF and IEF has been, may be and/or are currently held in several TOPS portfolios.

ValMark Advisers, Inc. (“ValMark”) is a federally registered investment adviser located in Akron, Ohio. ValMark and its representatives are in compliance with the current registration and notice filing requirements imposed upon federally covered investment advisers by those states in which ValMark maintains clients. For registration or additional information about ValMark, including its services and fees, a copy of our Form ADV is available upon request by contacting ValMark at 1-800-765-5201.

This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal.

Past performance is no guarantee of future results. Information contained herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.  Indexes are unmanaged and cannot be directly invested in.

Source: Bloomberg for historic price and return references. TOPS® is a registered trademark of ValMark Advisers, Inc.