If you ask rate traders, they're almost certain that the Federal Reserve will vote to increase its benchmark rate by 0.25% at the Wednesday meeting. Data from the CME Group suggests that traders have priced the odds of a 0.25% rate increase at 99.6%, implying little to no chance that rates are kept at the current target of 0.75% to 1.00%.
The general level of interest rates has an impact on virtually all businesses, but some are more exposed than others. Here are a few possible winners and losers if the Fed raises rates.
Winners: Asset-sensitive banks
Banks are the go-to "rate trade," but not all banks benefit equally. Some banks use hedges to reduce how interest rates affect their income. Others write fixed rate loans, which stand to delay the impact of higher rates on their income statements.
Few banks have as much exposure to interest rates as SVB Financial Group (NASDAQ:SIVB). In a recent presentation, the company noted that each quarter-point increase in rates would add $54 million to net interest income, or about $35 million after tax. That equates to an easy 8% increase in trailing twelve month earnings from every quarter-point jump. National banks like Bank of America (NYSE:BAC) which is one of the most rate-sensitive large cap banks, would stand to see its earnings jump by about 2% from a quarter-point increase.
As a general rule, the biggest winners from interest rate increases are banks which have the highest percentage of their assets tied up in securities (short-term Treasuries and commercial paper), and which derive a significant share of their deposits from money market accounts, which tend to pay little in interest to depositors. With respect to lending, however, banks benefit most when short-term rates and long-term rates is high.
The real estate industry has taken its fair share of lumps from doom and gloom in the retail industry, but there's more to the REIT story than the underlying fundamentals of their tenants. REITs are put into a broad category of "bond surrogates," or stocks that trade more like bonds, which fall as rates rise.
As interest rates rise, the "safest" REITs with the lowest yields often take the hardest fall. Companies like Realty Income, which is universally loved for its 19-year history of consecutive dividend increases, enjoy lofty valuations and low dividend yields. But as interest rates increase, investors demand higher yields from REIT shares, an adjustment that comes in the form of lower share prices. REIT dividend yields are most correlated with 10-year Treasury yields, but short-term rates obviously play a role, too.
Online stock brokers seem like an unlikely interest rate play, until you consider that most have banking arms that dwarf their brokerage businesses. Charles Schwab (NYSE:SCHW) is most exposed to rate increases. The company noted at its annual shareholder meeting that a 0.25 percentage point rate increase would lead to $200 to $300 million of incremental interest revenue in the following year, much of which would flow directly to pre-tax profit.
At the mid-point, that's good enough for a roughly 8% lift in pre-tax income from each quarter-point increase. Of course, there are a lot of variables at play -- how much cash its investors hold in their brokerage accounts, the actual rate Charles Schwab can earn on deposits when they are loaned out or invested, and so on -- but stock brokers are actually one of the few businesses that benefit tremendously from rate increases on the short-end of the yield curve.
Another bond surrogate is at risk if rates move higher. Regulated utility stocks are beloved for their predictable, royalty-like profits from monopoly power facilities that power America's homes and businesses, alike. But their reliable dividend distributions that attract yield-seeking investors to the sector become less impressive when higher yields on bonds offer a more compelling alternative.
The industry's bellwether ETF, Utilities Select Sector SPDR ETF (NYSEMKT: XLU), yields just 3.1% based on its trailing twelve month distributions. Should the Fed raise its target rate to 1.25%, utilities will offer a meager 1.85 percentage point yield premium to super-safe, short-term government bonds. Is that sufficient yield to keep investors' interest? Perhaps for a time, but eventually, investors may discover that they're taking stock-like risks for bond-like compensation.