5 ETFs Strategies To Prepare For Higher Rates

By Sweta Killa of Zacks.com

Wednesday, August 5, 2015 1:44 PM EDT

With an improving economy and an accelerating job market, the prospect of interest rates hike is moving closer despite global growth concerns. The Fed indicated its confidence in the economy in the latest FOMC meeting and confirmed that it is on track to raise the interest rates for the first time since 2006, sometime later this year (read: Top and Flop ETFs Post Fed Meeting).

In fact, Atlanta Fed President Dennis Lockhart yesterday stated that the interest rates hike could come as early as next month.

This is especially true given that the first-quarter slump in the U.S. seems to have been tided over with 2.3% economic expansion in the second quarter. The economy created at least 200,000 jobs in 13 of the past 15 months with broad-based gains and unemployment dropping to the seven-year low of 5.3%. Further, economic activity has been rising moderately, consumer confidence and spending has increased, and the housing market is seeing frenzied demand for homes.

While the overall economy is gaining momentum lately, subdued inflation, lower business investments, and soft exports continue to weigh on economic growth. As such, uncertainty still looms around the timing of interest rates. The Fed also indicated that the path of rate hikes would be gradual, meaning that the Fed will take baby steps once embarks on the trail of increases.

Given this, investors should be well prepared to protect themselves from higher rates albeit at a slower pace. Here are number of strategies that could prove extremely beneficial for ETF investors in the rising rate environment:

Financial Sector Remains a Hot Spot

A rising interest rate scenario would be highly profitable for the financial sector. This is because the steepening yield curve would bolster profits for banks, insurance companies and discount brokerage firms. A broad way to play this trend is with Financial Select Sector SPDR Fund (XLF - ETF report), which has a Zacks ETF Rank of 1 or a ‘Strong Buy’ rating (read: Top Ranked Financial ETFs in Focus on Improved Outlook).

Other top-ranked funds targeting the niche segment of the broad financial sector are SPDR S&P Regional Banking ETF (KRE - ETF report), SPDR S&P Bank ETF (KBE - ETF report) and PowerShares KBW Capital Markets Portfolio ETF (BKLN). These funds have a Zacks ETF Rank of 2 or ‘Buy’ rating.

Hedge with Niche Bond ETFs

Though the fixed income world is the worst hit by the rising rates scenario, a number of ETFs that employ some niche strategies like PowerShares Senior Loan ETF (BKLN - ETF report), iShares Floating Rate Note ETF (FLOT - ETF report) and iPath US Treasury Steepener ETN (STPP - ETF report) could lead to huge gains. This is because the senior loan funds are floating rate instruments and thus pay a spread over the benchmark rate like LIBOR, which help in eliminating interest rate risk (read: Hedge Rising Rates with Floating Rate ETFs).

On the other hand, floating rate note ETFs pay variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates compared to traditional bonds.

Further, the Steepener ETN directly capitalizes on rising interest rates. The note looks to follow the Barclays US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts. The fund takes a weighted long position in 2-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts.

Be Safe with Zero or Negative Duration Bonds

Zero or negative duration bond ETFs provides exposure to traditional bonds while at the same time short Treasury bonds using derivatives such as interest-rate swaps, interest-rate options and Treasury futures. The short position will diminish the fund’s actual long duration, resulting in a zero or negative duration. As a result, these bonds could act as a powerful hedge and a money enhancer in a rising rate environment. Currently, there are two zero duration and two negative duration bond ETFs from a single issuer – WisdomTree.

The zero duration funds include WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD - ETF report) and WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD) while negative duration fund include WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND - ETF report) and WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND). AGND has duration of approximately negative 5 years while HYND has negative 7 years duration (read: Negative Duration Bond ETFs: Right Time to Bet?).

Beat the Market with ex-Rate Sensitive ETF

Concerns over the rising interest rates are resulting in higher volatility in the market. In order to protect from both these issues, investors should considerPowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio ((XRLV - ETF report)). This fund provides exposure to 99 stocks of the S&P 500 that have both low volatility and low interest rate risk. It recently debuted in the space and has gathered $63.9 million in its asset base within four months (read: 5 Successful ETF Launches of Q2).

Short Rate-Sensitive Sectors

Investors worried about higher interest rates could also go short on rate sensitive sectors like utilities and real estate via ETFs. There are a number of inverse or leveraged inverse products currently available in the market that offer inverse (opposite) exposure to these sectors. While a leveraged play might be a risky option, inverse ETFs are interesting choices and provide hedging strategies in a rising rate environment.

There are a handful of ETFs in this corner of the investing world. ProShares UltraShort Utilities ETF (SDP - ETF report) is the only inverse ETF in the utility space employing a double-leveraged factor. In the real estate sector, there are three options – ProShares Short Real Estate ETF (REK - ETF report), ProShares UltraShort Real Estate ETF (SRS) and Direxion Daily Real Estate Bear 3x ETF (DRV) – having leveraged factor of 1, 2 and 3, respectively.

Get the latest research report on XLF - FREE