The winding down of economic stimulus by central banks in Canada and the United States has investors readying for rising interest rates in the coming months.
While higher rates are bad for borrowers, there are sectors of the economy (and market) that benefit. For instance, financial services companies can take advantage of the wider spread between the rates they charge borrowers and what they have to pay savers. Commodities and consumer discretionary stocks also tend to do well, as companies benefit from the economy picking up steam.
We asked three investment professionals for their view of the market landscape in a rising rate environment – and specifically which Canadian exchange-traded funds are likely to benefit from higher interest rates.
Ryan Lewenza, senior vice-president and portfolio manager, Turner Investments of Raymond James Ltd.
“We believe there is only one direction to go for rates, and that’s up,” Mr. Lewenza says. “In this environment, investors will need to reposition their portfolios accordingly.”
He believes investors should maintain their equity allocation, as stocks tend to outperform bonds while the economy is growing and rates are rising. He also believes that high-quality dividend-paying stocks are a must-have, as companies will likely increase their payout rates during this period.
A booming economy typically means strong corporate profits, he adds, which allows companies to boost their payouts. They will also be compelled to raise their dividends to keep up with higher rates paid on savings accounts and bonds.
An ETF Mr. Lewenza expects to do well as rates rise is the BMO S&P/TSX Capped Composite Index ETF (ZCN-T), which tracks Canada’s main stock index. Some of its top holdings include market darling Shopify Inc., as well as the big banks. It also has significant positions in many resource companies such as Enbridge Inc., Canadian Natural Resources Ltd. and Suncor Energy Inc. The allocation fits with his belief that investors will need to increase their exposure to commodities and resource companies.
“Interest rates are rising due to strong economic growth, which generally translates into stronger demand for commodities,” he says. He sees this ETF as a simple, diversified way to take advantage of this trend. He also likes the fund’s “very low” management expense ratio (MER) of 0.06 per cent.
Mr. Lewenza also offers a recommendation on the fixed income side – the Mackenzie Floating Rate Income ETF (MFT-T), with an MER of 0.67 per cent. He highlights the fund’s “attractive yield” of around 4 per cent and notes that, since the fund holds floating-rate bonds – which are typically below investment grade and offer yields that exceed conventional fixed income instruments – investors will receive higher interest payments as central banks hike rates. The fund also provides a good hedge on inflation and rising rates, as the performance of the floating-rate bonds tends to be less sensitive to interest rate fluctuations compared to fixed-rate bonds.
Linda Ma, analyst, ETFs and financial products, National Bank of Canada
Ms. Ma says the financial sector will be a major beneficiary of rising rates – specifically banks and insurance companies. She notes that in a rising rate environment, banks typically benefit from the wider spread between the interest rates they charge on loans and what they pay on deposits. She also says that with the recent lifting of capital distribution restrictions for Canadian banks, their return on equity may get a further boost.
For specific bank-related funds that could do well in a rising rate environment, Ms. Ma highlights the BMO Equal Weight Banks Index ETF (ZEB-T), with an MER of 0.28 per cent, which ensures continuing diversification by equally weighting its ownership of Canada’s Big Six banks. She also likes the Horizons Equal Weight Canadian Banks Index ETF (HEWB-T), which uses swap contracts to replicate returns, rather than directly holding the underlying securities. The fund has an MER of 0.33 per cent.
Insurance companies typically take the premiums paid by their customers and invest them, largely in a fixed-income portfolio. Ms. Ma notes both property and casualty and life insurers stand to generate stronger investment returns in a higher interest rate environment. To take advantage of this trend through a Canadian-listed ETF, she recommends the iShares Equal Weight Banc & Lifeco ETF (CEW-T), which invests in Canada’s Big Six banks as well as the country’s top insurance companies such as Sun Life and IA Financial. It has an MER of 0.61 per cent.
John Hood, president and portfolio manager, J.C. Hood Investment Counsel
Mr. Hood is also a believer in the concept that banks typically do well when interest rates are going up. Like Ms. Ma, he recommends the BMO Equal Weight Banks Index ETF as a good way to take advantage of this trend. He also notes the fund used to have a high MER for what might be considered a “plain vanilla” fund, but that has recently been reduced from 0.60 per cent to 0.28 per cent.
His preferred alternative for the fixed-income portion of a portfolio are funds that use a covered-call strategy to achieve enhanced returns, such as the BMO Covered Call Canadian Banks ETF (ZWB-T), which has an MER of 0.72 per cent. The fund’s strategy lets it participate in the upside of bank stocks amid rising rates thanks to an expected increase in net interest margins.
As interest rates rise, some bond funds such as the BMO Ultra Short-Term Bond ETF (ZST-T), the iShares Core Canadian Short Term Bond Index ETF (XSB-T) and the BMO Aggregate Bond Index ETF (ZAG-T) could make sense, Mr. Hood says. Their MERs range from 0.09 per cent to 0.16 per cent.
By holding bonds that have a short term to maturity, and are investment-grade, he says the ZST fund should outperform in this environment.
However, in general, Mr. Hood isn’t a fan of bond ETFs, especially over the long term. “Why bother with them when you can get 5 per cent in covered calls,” he says, adding that many bond funds have lost value so far this year.
“I’ve been tempted to get back in bond funds a few times over the past years. Thank God I didn’t.”