After lackluster performances last year, regional banks led the financial sector higher for most of this year. This space has been a solid player as a strong dollar and global growth concerns compelled investors to look for U.S. exposure.

Additionally, rising speculations for a rates hike have largely benefited regional banks in recent months on the steepening yield curve. This is because these banks seek to borrow money at short-term rates and lend at long-term rates. If interest rates rise, the banks would be able to earn more on lending and pay less on deposits. This would expand net margins and bolster banks’ profits (read: Regional Bank ETFs to Watch as Rate Spread Widens).

Rates Hike in Cards

In its latest FOMC meeting, the Fed clearly stated that it is on track to raise interest rates sometime later this year given the substantial improvement in the economy after a winter swoon but the timing is still uncertain. Further, the pace of increase would be slower and gradual than market expectation, citing concerns over still low inflation and job market recovery.

As such, the first rate hike since 2006 will only take place when the job market continues to show strong progress and inflation rises to the 2% target over the medium term. If this happens, the Fed officials are expecting at least one or perhaps two rate increases this year. Though short-term interest rates will rise slowly, a strengthening economy and accelerating job market will drive long-term interest rates higher, thereby widening the spread between the long and short-term rates.

To make it clear, let’s look at the yield of the short-term and long-term bonds. The yield on 10-year Treasury bonds rose to 2.320% from 2.128% at the end of May while the yield on 3-month Treasury bonds was relatively flat at 0.010% since the start of June. The yield spread is currently 2.31% at the time of writing as against 2.118% at the end of May, reflecting higher spreads and resultant higher profits for the banks (read: Fight Rising Yield with These High Yield ETFs).

In fact, the yield curve between 5-year notes and 30-year bonds steepened to 150 bps on June 18, representing the steepest yield curve in a month following the upbeat economic data on inflation that strengthened the Fed rate hike stance.

Other Factors

Most of the regional banks now have much stronger balance sheets and their quality of earnings is improving on a step-up in the economy. Added to the strength is solid loan growth, higher trading income, rising credit quality and litigation settlements. As the banks’ loan portfolio gains health, they will need less loan loss reserves in the future pointing to gainful trading for banking stocks.

Given encouraging fundamentals, investors are seeking to bank on this regional banking space. For those, any of the following ETFs could be solid picks to ride out the steepening yield curve:

SPDR S&P Regional Banking ETF (KRE - ETF report)

This is one of largest and the most popular ETFs in the banking space with AUM of nearly $2.5 billion and average daily volume of more than 4 million shares. The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. Holding 91 securities in its basket, the fund is widely spread out across each security with an equal-weigh approach of around 1%. Small caps dominate the fund’s return at 76%, followed by mid caps (18%) and large caps (6%). The fund has gained about 10% in the year-to-date time frame (read: Bank ETFs Hitting Multi-Year Highs as Rates Hike Nears).

iShares U.S. Regional Banks ETF (IAT - ETF report)

This ETF offers exposure to 53 regional bank stocks by tracking the Dow Jones U.S. Select Regional Banks Index. Large caps dominate more than half of the portfolio with U.S. Bancorp (USB - Analyst Report) and PNC Financial Services (PNC -Analyst Report) taking the largest share with a combined 31% of assets. Other firms hold no more than 7.13% share. The fund has amassed $550 million in its asset base and sees good volume of 201,000 shares a day. It charges 43 bps in annual fees and is up 7% so far this year.

PowerShares KBW Regional Banking Portfolio (KBWR - ETF report)

This fund follows the KBW Regional Banking Index, holding 50 stocks in its basket with each accounting for less than 4% share. It is a small cap centric fund as these account for 85% of the portfolio while the rest goes to mid caps. The ETF is often overlooked by investors as depicted by its AUM of $41.4 million and average daily volume of under 5,000 shares. It charges 35 bps in fees per year from investors and added over 10% in the year-to-date time period (see: all the Financial ETFs here).  
 

Bottom Line

These products have clearly outpaced the broad financial ETF - Financial Select Sector SPDR Fund (XLF - ETF report) by wide margins and are expected to outperform given the bullish trends and imminent rates hike later this year.