Take Advantage of Higher Interest Rates With These 2 Stocks

Interest rates have risen significantly over the past year or so, and most experts agree that we'll see several more rate hikes over the next few years.

Rising rates affect different types of stocks in different ways. Some stocks can benefit from rising rates, some can be under pressure as rates rise, and some don't tend to react much to interest rate moves at all. With that in mind, here are two rather different stocks that can let you take advantage of the current interest rate environment.

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Data source: TD Ameritrade. Prices and yields current as of 5/21/18.

Higher rates could mean big profits for Bank of America

There are plenty of reasons to like bank stocks, and Bank of America in particular. The bank has done a great job of transforming itself in the decade or so since the financial crisis ended. Its asset quality is much improved, its business has grown significantly (and responsibly), and it has aggressively returned capital to shareholders in recent years.

In addition, the bank's efficiency has improved tremendously in recent years thanks to the strategic closure of underperforming branches, investment in cost-saving technologies, and general emphasis on expense reduction. Since the end of 2015, Bank of America's efficiency ratio is down (lower is better) by an impressive 900 basis points to 60% -- on par with the leading big banks. This, combined with the benefits of tax reform, has pushed Bank of America's profitability above the industry's 1% return on assets and 10% return on equity benchmarks for the first time in years.

And finally, Bank of America has a big potential catalyst as interest rates rise over the next couple of years. With an above-average concentration of noninterest-bearing deposits, Bank of America should be a big beneficiary as interest rates rise. According to the bank's management, a 100-basis-point parallel shift in the yield curve would translate to an additional $3 billion in net interest income per year.

With the latest Federal Reserve forecasts calling for further hikes to the federal funds rate of 175-200 basis points by the end of 2020, we could see Bank of America's profitability grow significantly.

Rising rates have pummeled the real estate sector

Real estate investment trusts, or REITs, have been one of the worst-performing parts of the stock market recently. While the S&P 500 is up by nearly 15% over the past year, the Dow Jones Equity REIT Index has actually dropped by 4%. Healthcare REIT Welltower has done even worse, with a troubling 25% fall.

The main cause for the broad drop in REITs is interest rates. Simply put, when rates rise, income-oriented investments like REITs tend to face downward pressure. Investors have the choice between risk-free income investments like Treasuries and “riskier” investments like REITs. When the yield that’s available from risk-free investments rises (the 10-year Treasury is a good indicator for REITs), investors expect the risk “premium” they receive from REITs to rise as well. When stock prices drop, yields rise.

To be sure, there are some reasons rising rates are bad for REITs like Welltower business-wise. For example, rising rates means it will cost more for Welltower to borrow money to acquire new properties. However, the majority of the price decline has more to do with macroeconomic conditions than with Welltower’s business itself. In other words, Welltower’s business isn’t much worse off than it was two years ago, but the stock now trades for 17% less and has a 24% higher dividend yield than it did then.

In Welltower's case, oversupply worries have added to the pessimism. Welltower's primary property type is senior housing, which makes up nearly three-fourths of the company's portfolio.

Senior housing is a big long-term growth industry (more on that in a bit), but there are signs that the market may have built too much. We're seeing this in a few different types of commercial real estate -- with the extremely low costs of capital in recent years and elevated real estate values, it has simply been cheaper in many cases to build new properties rather than acquire existing ones.

However, it's important to realize that this isn't a long-term problem. The senior citizen population in the U.S. is expected to grow rapidly in the coming decades, with the 85-and-older age group (the primary demographic of senior housing) expected to double over the next 20 years.

It may take some time before the industry headwinds cool off, but in the meantime, you're getting a top-notch REIT for just 13.6 times the company's 2018 FFO guidance (the REIT version of earnings), and you'll be getting paid a 6.4% dividend yield while you wait. To be clear, Welltower could remain under pressure as rates keep rising -- especially if it happens faster than expected. However, now could be an excellent time for long-term investors to think about adding Welltower to their portfolios while the stock is down.

Two very different plays on rising rates

These are two very different plays on the current state of interest rates: one that could profit as rates continue to rise, and one that has been under pressure because rates have risen. However, both could be excellent additions for investors who have long time horizons to work with.