2 Ways To Profit From Tomorrow's Interest Rates

Adam Fischbaum's picture

Tuesday, September 13, 2016 - 12:30pm

by Adam Fischbaum

Ok. I was a little early with my call on rising bond yields.

In fact, they actually went down a little after I wrote that article. However, last week, bonds saw a healthy sell off which, naturally, bumped interest rates up. The blame fell on hawkish comments from a Fed official concerned about an economy that could overheat due to stubbornly low interest rates.

Maybe someone should remind him that they've already gone up in the past year.

When the Federal Reserve raised their target Fed funds rates (the interest rate they charge member banks) towards the end of last year, they literally more than doubled interest rates. And with Fed Funds being right at 40 basis points, the Fed is within striking distance of its current target for the Fed Funds rate of 50 basis points.

Stock markets reacted negatively to the change, and stayed depressed until spring of this year. But bond yields stayed stubbornly low. That may be changing.

Since bottoming in July, the yield on the 10-year treasury has risen 22%. The longer end of the treasury yields has also gone up.

On average, long rates are up 17%; a significant number. With that, I think the odds of the Fed raising rates this month are extremely low. I also think the likelihood of a rate hike in December is low. Rates are taking care of themselves.

Will the sky fall? No. Although, I do think the bond market will experience some volatility as prices adjust. And some of that volatility may spill over to the equity markets. But we may see some strengthening in the overall economy as rates rise gradually. How? Bank lending.

The original intention of the Fed's massive quantitative easing response in the wake of the Financial Crisis of 2008 was to reliquify the economy by providing banks with cheap capital that the banks would, in turn, lend to consumers and businesses. That didn't happen.

The banks sat on the gigantic piles of money mainly out of fear. This partially explains the tepid recovery in the U.S. economy. But after eight years, the banks are starting to loosen up. According to Federal Reserve data, commercial and industrial loans have grown at a 9% rate year over year from $1.89 trillion in August of 2015 to $2.06 trillion in August 2016. That's a healthy number. Slightly higher rates translate into higher margins and better earnings for banks.

This Bank Is Your Best Bet
Now, I'm not too bullish on most bank stocks. However, Wells Fargo (NYSE: WFC) is worth a look as banks stand to benefit from higher rates.

There's a reason that Warren Buffett's Berkshire Hathaway (NYSE: BRK-B) owns 10% of the company's outstanding shares: high quality at a value price.

Wells shares trade at a nearly 15% discount to their 52-week high at around $48 with a forward P/E of 11.46 and an annual dividend yield of 3.1%. 2015 revenue clocked in at a solid $90 billion up 2% from 2014's $88.3 billion. Not a huge jump, but respectable.

The company is expected to earn $4.18 per share this year which would top last year's results of $4.03 by nearly 4%. The ability to benefit from higher long rates could boost that number.

Who Else Stands To Benefit From Rising Rates?
While banks would be the most obvious beneficiaries of slightly higher interest rates, non-bank financial stocks could get a lift as well. I've always been a fan of the asset managers in the non-bank space.

The LP units of fund manager Alliance Bernstein (NYSE: AB) are an attractive idea at current levels. Units trade at around $22 with a forward P/E of 11.25 and a fat 7.27% dividend yield (remember it's a master limited partnership). While the volatility created by higher rates may pose a near term risk to the company's portfolio holdings, higher yielding investments will create opportunity, increase portfolio yields, and attract new investors generating higher fees. This would translate into increased distributions along with a higher stock price.

Risks To Consider: While a gradual rise or "normalization" in interest rates is a net positive, a broader more violent selloff in fixed income markets is the biggest risk to these stocks, financial markets and the global economy as a whole. The fear created could generate a negative feedback loop that could shatter the fragile progress we're seeing across most economies.

But while that is a major concern, most world central banks are still in the early innings of their QE games while the United States is trying to wind its adventure down. There should be enough liquidity out there, provided mainly by the European Central Bank, to temper any unforeseen shocks.

Action To Take: WFC and AB shares have a blended dividend yield of 5.18% and an average forward P/E of just 11.35. A 20% expansion of the forward P/E to just 13.6 would boost the prices of the stocks by 17% on average. With the dividends, the end result would be a total return of better than 22%.

Adam Fischbaum owns WFC and AB in family and managed family accounts.

Editor's Note: Brace yourself for a tough year in 2017. We don't yet know who our next president will be. But one truth is impossible to ignore: for nearly two centuries our economy (and investment landscape) has disintegrated in an election year. And it's going to happen again... discover 3 election-proof investments that will be impervious to the nation's losses.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.