Afraid Of A Rate Hike? Don’t Sell These Stocks…

If there’s one topic that has defined investing this year, it has been investor fear of rising interest rates. After more than six years of historically low rates, it was all but inevitable that the Federal Open Market Committee (FOMC) would finally begin to increase rates starting this year.

That fear has lead investors to sell their stocks in rate-sensitive sectors such as utilities and consumer staples. Traditional thinking says that higher interest rates could put the dividends for those investor staples at risk. As for the rest of the market, many worry that higher borrowing costs would weigh on the economy and send the entire market reeling.

As a result, the S&P 500 went nowhere for most of the year. Then in mid-August, with bets rising on a September rate hike, the market tumbled 11% in just over a week.

While the market has recovered from that fall, the odds are back on for a rate hike after the December FOMC meeting…  

But if you’re thinking it’s time again to sell your utilities or consumer staples, you’re wrong.

Rising Rates Could Be Great For These Sectors
While the theory that rate-sensitive sectors should underperform when rates rise is intuitive, historical performance suggests something else.

Separating annual returns by the change in interest rates since 1999 shows that utilities and REITs outperformed the general market except when rates increased very quickly. When rates fell, as in during a recession, the sectors provided tremendous support from negative returns in other sectors.

As you see above, utilities, consumer staples, and REITS can actually outperform the market in times of rising interest rates. 

And I think the next few months will see the same results.

Studies show that the economy can feel the full effects of a rise in interest rates in as little as six months. That means that we can expect borrowing costs to rise fairly quickly, knocking out a particular safety net that many companies have been relying on to keep share prices stable: buybacks. For awhile now many industries have seen lackluster sales growth, so companies across the market have been able to engineer higher earnings through share repurchases funded on low rate debt. When rates go higher, not only could higher borrowing costs hit consumer spending and sales but companies may think twice about spending their hard-earned cash on share buybacks.

So if the economy were to stumble, traditionally rate-sensitive sectors like utilities, consumer staples and REITs could save your portfolio as other sectors tumble.

These Sectors Should Beat The Market If Rates Rise
Stocks of utility companies outperformed the S&P 500 in every tranche except when treasury rates rose more than 9 percentage points over the year. Even in the two fastest rate-increase tranches, utility stocks posted positive returns. In the four tranches where the market (shown in blue) fell, utility stocks outperformed by 3% on average.

Few utility companies have been hit as hard as NRG Energy (NYSE: NRG) on the prospect of rising rates and falling fuel costs. The company has spun off its clean energy business and may sell a portion in a partnership agreement to reduce ongoing costs. Along with other cost savings around a restructuring plan, it could free up a lot of cash to return to shareholders. The shares pay a persuasive 4.9% dividend yield and trade for just 0.44 times book value.

Shares of REITs outperformed the market in every tranche except when rates fell between 10% and 13.9% and when rates rose more than 20%. The underperformance in the falling rates tranche is due to fallout over the housing crisis and REITs still posted an average 18% gain when interest rates jumped. REITs outperformed the market by 4.5% when the economy took the S&P 500 lower.

The Vanguard REIT ETF (NYSE: VNQ) provides instant diversification across 144 real estate companies. The expense ratio of 0.26% is lower than 80% of similar funds and well under the 3.9% dividend yield it pays annually.

Consumer staples was the only sector to post positive returns in every single tranche. It only outperformed the market in the four scenarios with the largest rate drops but beat the market by an average 8.6% over the period.  

Philip Morris International (NYSE: PM) has underperformed the S&P 500 by 0.77% this year but could prove its status as a safety play if the market stumbles. The company controls 28% of the global market share for tobacco, excluding the United States and China, making it the largest player in the world. Shares pay a 4.7% dividend yield and trade for just under 19 times trailing earnings.

Risks to Consider: Rates will likely increase over the next year and rate-sensitive sectors could be more volatile as investors bet on the pace of increases. Be ready to ride out greater fluctuations even if the overall trend should be higher for these sectors.

Action to Take: Take the contrarian view and increase your position in rate-sensitive sectors like utilities, REITs and consumer staples for safety ahead of a potential end to the bull market in stocks.

Editor’s Note: My colleague Nathan Slaughter has discovered a small group of dividend payers that he thinks every single income investor should own. He calls them his High-Yield Hall of Fame. These stocks have outlasted wars, depressions, recessions, financial panics and more — while still raising dividends year after year. To learn more about these elite income stocks, click here.