Despite a series of high-profile regional bank failures, tech sector layoffs and fears of a recession, the U.S. Federal Reserve remains staunchly committed to hiking the policy interest rate, which sets the interest rate at which commercial banks can lend and borrow from one another.
On May 3, Fed Chair Jerome Powell once again announced a 25-basis-point rate hike, as inflationis still a long way from the Fed's 2% long-term target rate. This latest rate hike came despite the failure of First Republic Bank, the latest victim in the ongoing banking crisis, and news that U.S. gross domestic product growth slumped from January to March.
For now, only time will tell if the Fed's spate of rate hikes will achieve the desired "soft landing" of taming inflation without inducing a recession. Regardless, many investors anticipate market volatility to remain elevated as participants price in the effects of the ongoing rate hikes.
"The purpose of rate hikes is to slow down economic growth and control inflation," says Wes Moss, managing partner and chief investment strategist at Capital Investment Advisors. "When the economy is growing too fast and inflation is rising like in 2021 and 2022, the Federal Reserve increases rates to discourage borrowing and spending, which helps slow down economic growth and stabilize prices."
However, despite their stabilizing effect on the economy's long-term prospects, rising interest rates can often hurt many investments.
"Warren Buffett once compared interest rates to gravity when it comes to asset prices," Moss says. "Increasing interest rates makes the cost of capital more expensive and current cash flows more important, which pull asset prices downward."
For an example of this, consider all the high-flying pandemic-era growth stocks, many of which have fallen significantly from their all-time highs. "In general, the most interest-rate-sensitive sectors are tech, communications and real estate," says Derek Horstmeyer, professor of finance at the George Mason University School of Business. "When the Fed raises interest rates, these sectors usually fall the most."
Also significantly impacted by rising rates are fixed-income assets such as bonds. When interest rates rise, bond prices fall to make their yields more competitive with current rates. This is governed by duration, a measure of interest rate risk. Broadly speaking, longer-maturity bonds with greater durations have been the most sensitive to rate hikes and thus were one of the biggest losers throughout 2022.
That being said, investing during a hiking cycle doesn't mean just incurring losses. There are assets that have historically proven resilient to rate hikes, or even benefited from them. To access these assets, investors can buy exchange-traded funds, or ETFs, that provide transparent and cost-effective exposure.
Here's a look at seven of the best ETFs to buy when interest rates rise:
| ETF | EXPENSE RATIO |
| iShares 0-5 Year High Yield Corporate Bond ETF (ticker: SHYG) | 0.3% |
| iShares Floating Rate Bond ETF (FLOT) | 0.15% |
| Abrdn Physical Gold Shares ETF (SGOL) | 0.17% |
| Consumer Staples Select Sector SPDR Fund (XLP) | 0.1% |
| SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) | 0.14% |
| ProShares S&P 500 Dividend Aristocrats ETF (NOBL) | 0.35% |
| Vanguard Total World Stock ETF (VT) | 0.07% |
iShares 0-5 Year High Yield Corporate Bond ETF (SHYG)
"Now that rates are rising, ETFs like SHYG could be extremely attractive," says Christopher Manske, president at Manske Wealth Management. "Because bond prices tend to go down when interest rates go up, this means ETFs like SHYG have been beat up a bit recently." For investors who don't mind greater credit risk, a high-yield bond ETF like SHYG pays a higher yield to maturity of 8.2% right now.
Even if interest rates continue to rise, ETFs like SHYG will be well insulated. Right now, this ETF only has an effective duration of 2.4 years. All else being equal, a 1-percentage-point increase in rates will result in a 2.4% loss for SHYG. "The ETF's short maturity means the managers are replacing maturing bonds with new, lower-cost ones as rates rise, while investors collect a great interest rate along the way," Manske says.
iShares Floating Rate Bond ETF (FLOT)
"If an asset's value is tied to interest rate movements, then rate hikes will benefit that asset," Manske says. "A floating-rate bond fund is an excellent example of this, but the problem is that everyone already knows this."
Still, in the event that inflation remains high and interest rates continue at the pace seen during the 1980s, then floating-rate bond ETFs like FLOT could offer protection.
FLOT indexes a portfolio of investment-grade floating-rate bonds with remaining maturities between one month and five years for a 0.15% expense ratio, which works out to $15 annually for a $10,000 investment. Currently, the ETF sports a very low duration of 0.03 years, showing its resilience to interest rate movements. Thanks to the recent rate hikes, FLOT is paying an average yield to maturity of 6%.
Abrdn Physical Gold Shares ETF (SGOL)
Another asset with a history of strong returns during rate-hiking cycles is gold, which typically exhibits a negative correlation with the U.S. dollar. "After the last interest rate hike in 2000, gold went on to rise 55.8% through early 2004," says Robert Minter, director of ETFs investment strategy at Abrdn. "The same occurred after the hike in 2006, where gold went on to rise 230.6% through late 2011."
An alternative to physical bullion that can offer spot-gold price exposure in any brokerage account is SGOL. "SGOL is a transparent 'physical gold' ETF which buys gold bars, stores them in audited vaults and avoids futures contracts," Minter says. Investors therefore receive proportional exposure to the underlying gold bullion in exchange for a relatively low 0.17% expense ratio.
Consumer Staples Select Sector SPDR Fund (XLP)
"Consumer staples companies such as food processors, grocery stores and makers of personal care products may also be more resilient to rate hikes," says Jim Penna, manager of retirement services at VectorVest Inc. "These businesses are centered around essential goods and services. This makes their margins and earnings less likely to be impacted by the higher rates."
For a straightforward way of indexing America's most prominent consumer staples companies, investors can buy XLP. "This ETF tracks the consumer staples sector of the S&P 500 index, which includes companies involved in food, household products, tobacco and other personal products," Penna says. XLP currently has 37 holdings and charges a 0.1% expense ratio.
SPDR Bloomberg 1-3 Month T-Bill ETF (BIL)
"I also like BIL as it focuses on Treasury bills, or T-bills, with one-to-three months' maturity remaining," Penna says. "Short-term Treasurys are about as safe as you can be at this point, so it's a good place to allocate a portion of your portfolio if you have a low risk tolerance."
Thanks to the rising interest rates, BIL pays a decent yield to maturity of 5.2%.
In terms of risk, BIL is as safe as it gets. With an average duration of 0.08 years, BIL is only expected to lose 0.08% if rates rise by 1 percentage point, all else being equal. Its portfolio is held solely in U.S. government-issued T-bills, long regarded as the "risk-free" asset due to their high credit quality and virtual lack of default risk. Currently, BIL charges a 0.14% expense ratio.
ProShares S&P 500 Dividend Aristocrats ETF (NOBL)
"While each rate-hiking cycle is accompanied with specific characteristics and different quirks, owning blue-chip companies with strong balance sheets and consistent free cash flow that have weathered the storm during multiple economic downturns is never a bad idea," Moss says. These tend to be large-cap stocks with robust profitability that form the backbone of most indexes.
"Companies that exhibit those characteristics usually not only pay dividends but tend to grow them year after year after year," Moss says. An ETF that targets the most long-standing of these companies is NOBL, which only holds dividend aristocrats from the S&P 500. These are stocks with a history of growing dividend payments consecutively for at least 25 years. NOBL charges a 0.35% expense ratio.
Vanguard Total World Stock ETF (VT)
"The Federal Reserve has been raising interest rates for a year now, which has created some uncertainty in the markets," says Sophoan Prak, certified financial planner at Vanguard Advisers. "However, despite rising rates and market uncertainty, investors should stay disciplined and committed to their long-term retirement strategy." This means ignoring the recent noise and staying the course.
For most investors, the current interest rate turmoil is unlikely to spell doom for a diversified, long-term portfolio. "We believe in the benefits of global diversification, and a market-weighted index ETF can provide those benefits," says Prak. To put this into play, long-term investors can buy VT, which provides exposure to over 9,000 domestic and international stocks around the world for a 0.07% expense ratio.
https://money.usnews.com/investing/funds/slideshows/7-etfs-to-buy-as-interest-rates-rise
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