By Michael Foster
ItaEURtms a question I get from investors all the time (including subscribers to my CEF Insider service ): how should I invest when interest rates rise?
Because fear of rising rates is common among investors, thereaEURtms a hidden trap here: if you react to this worry, you will lose money. Instead, you need a second-level understanding of rates so you can bet against this fear and make money. (IaEURtmll also give you 3 great buys that let you quickly and easily pull this off below.)
What Most People Get Wrong About Rising Rates
HereaEURtms the common thinking on rates: as they head up, rising yields on US Treasuries will make these investments more attractive than large-cap US dividend stocks . At the same time, corporate borrowing costs will rise, handcuffing American companiesaEURtm profit growth. Higher rates will also drive up the dollar, causing foreign stocks to fall. In short, rising rates are bad news for pretty much all stocks.
This paragraph has a grain of truth to it, but itaEURtms also misleading.
Because higher rates might in theory attract capital from dividend stocks, and they do boost corporate borrowing costs. But just focusing on these two angles ignores why rates are rising in the first place: inflation is getting stronger and economic growth is strengthening. These are both bullish signs for stocksaEUR"and theyaEURtmre much more important to stock fundamentals than interest rates.
ThataEURtms why both large-cap dividend stocks (which make up the iShares Select Dividend ETF [DVY] ) and the tech stocks in the Invesco QQQ Trust ( QQQ ) are up solidly over the last three years, since the Federal Reserve kicked off the current rising-rate cycle:
Rates Rise, Stocks Rise
Of course, things didnaEURtmt start off with such optimism. Rate-hike fears caused a panic selloff in late 2015, which you can see here:
Short-Term Fears Create a Buying Opportunity
This happened again in early 2018, and anyone who has been observing the market this year knows what happened as a result. Over the long term, the S&P 500 recoveredaEUR"and itaEURtms currently up a strong 7.8% year to date, excluding dividends.
The lesson? DonaEURtmt sell on short-term rate panics: thataEURtms the time to buy.
3 Great Rising-Rate Buys
The clearest way to profit from the marketaEURtms absurd rate fear is to buy into assets that have been hit hardest in the latest panic. And right now, that means three sectors: utilities, preferred stocks and real estate investment trusts (REITs) .
These are all asset classes that are sensitive (in the short term) to rates, and they also boast large dividends. As a result, first-level investors have sold these off, setting up bargains.
For instance, the CBRE Clarion Global Real Estate Income Fund ( IGR ) is a closed-end fund ( CEF ) that holds REITs and trades at an 11.6% discount to its net asset value ( NAV ) while paying a generous 8% dividend yield. I know that sounds unsustainable, but because of the fundaEURtms discount, fund managers only really need to get a 7.1% return to sustain those payoutsaEUR"and theyaEURtmve been doing that easily over the last few months:
A Safe 8% Dividend
With a 7.2% annualized NAV return, IGRaEURtms dividend looks sustainable in the months ahead, making it an interesting contrarian play on rate fears.
Another contrarian way to grab high income from the rising-rate hysteria is, as I mentioned a second ago, through utilities. And you can get 6.6% income at a 5.3% discount in this reliable aEURoewidows and orphansaEUR asset class with another CEF: the Reaves Utility Income Fund ( UTG ) , thanks in no small part to its incredible management team. ThataEURtms why UTG has crushed the index fund, the Utilities Select Sector SPDR (XLU) over the last decade:
Beating the Index
Nothing feels better than beating the index while getting an income stream thataEURtms double that of the index (UTGaEURtms 6.6% yield is double the 3.3% XLU pays).
My third way to bet on rising rates is the most contrarian: preferred shares . The Nuveen Preferred & Income Securities Fund (JPS) is down 13.7% in 2018. Even if we add in dividends, JPS is still down 9.2%aEUR"on the market.
However, this CEF trades at a huge discount thataEURtms gotten bigger in 2018; its 9.2% markdown is much larger than its average 5.2% discount over the last decade, and this one chart shows why:
Price Falls Fast Despite Stable NAV
JPSaEURtms 9.2% price decline is much larger than its 1.8% NAV decline in 2018, demonstrating the marketaEURtms rate-driven (and absurd) panic in selling off preferreds.
That has also helped JPSaEURtms dividend yield soar to 7.9%, far ahead of the 6.9% the fund needs to earn from preferreds to make its payout sustainable. ThataEURtms one of the lowest returns this fund has had to earn in a long time, which puts its dividend in the safest position itaEURtms been in quite a while.
Yet the fund has been selling off like itaEURtms a dangerous investment, which makes it a very attractive contrarian opportunity.
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