Profit From Rising Interest Rates With These ETFs

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Regional bank exchange traded funds severely lagged the market the past five years but it appears they've overtaken the market this year thanks to rising interest rates.

They stand to benefit most from rising long-term interest rates because such action widens their net interest margin, or the difference between the short-term interest rates at which they borrow and the long-term interest rates at which they lend.

The Federal Reserve has pledged to hold down short-term interest rates near zero until inflation  hits 2% and the unemployment falls below 6.5%, which could take years.

"But long-term rates can move higher because the markets expect more economic growth a year or so from now," said Paul Edelstein, director of financial economics at IHS, based in Lexington, Mass.

Rising mortgage rates and home values may jolt potential homebuyers to act now before rates rise further, thereby boosting demand for home loans.

In addition, when rates are rising, people, instead of putting their money in higher risk assets such as stocks, tend to save more thereby boosting bank deposits, says Tim Dyer, vice president of Sage Capital Advisors in La Jolla, Calif., with $150 million in assets under management.

"The bank expands its balance sheets and in turn relends that money at an attractive spread," Dyer said in an email. "This can drive earnings higher and ultimately the underlying share prices.

"Bank credit, while recovering, is rising at a slow and measured pace," Bank of America Merrill Lynch investing strategists wrote in a report June 6. "(BofA Merrill) data show that mortgage credit for housing purchases or refinancing has improved in the past 18 months, but from a very low base."

SPDR KBW Regional Banking ETF ( KRE ), the largest of its kind by assets, holds 78 equal-weighted stocks. It's returned 17% year to date and 26% in the past 12 months vs. 15% and 23% for SPDR S&P 500 ( SPY ). This marks a notable turnaround after lagging the market the past three years. KRE rose an average annual 12% over three years, while SPY averaged 16%.

IShares Dow Jones U.S.Regional Banks ( IAT ) holds 60 cap-weighted stocks. It most heavily weightsUS Bancorp ( USB ) at 21% of assets,PNC Financial Services ( PNC ) 12% andBB&T (BBT) 7%. IAT gained 17% year to date and 25% in 12 months.

PowerShares KBW Regional Banking Portfolio (KBWR) holds 50 stocks. Its largest holding,Susquehanna Bancshares (SUSQ), accounts for 4% of assets. The laggard among the three, KBWR is up 15% year to date and 20% in one year.

IAT trades at a discount compared with its peers and the market. It trades at nearly 13 times forward earnings and 1.2 times book value. The S&P 500 trades at a forward P/E of 15 and 2 times book value.

But banks and the broader financial sector as tracked bySPDR Financial Select Sector (XLF) still trade deep below their prebear market highs, suggesting they have more upside potential to "catch up" with the market.

A major risk is that new regulations from the Dodd-Frank Act in the next three years could squeeze banks' profits as they have to spend more time and money on compliance, says Bill Hammer, CEO of Hammer Wealth Group in Melville, N.Y. He recommends individual investors limit exposure to any individual sector ETF to 5% of their portfolio.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs
Referenced Symbols: IAT , KRE , PNC , SPY , USB

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