This year, rising inflation brought the actions of the Federal Reserve into full focus for investors. The Fed used its primary tool -- setting the prime interest rate -- to attempt to cool down inflationary pressures in the economy.
JPMorgan Chase (JPM 1.94%) President and Chief Operating Officer Daniel Pinto said the Fed doesn't want to allow inflation to become ingrained in the economy, and "putting inflation back in a box is very important." Pinto explained that after a decade of ultra-low interest rates, "real rates should be higher in the next 20 years than they were in the last 20 years."
Prolonged low interest rates weighed on many companies in the financial sector over the past decade. With rates near all-time lows for an extended period, companies like banks and life insurers saw profits get squeezed. That's because many companies generate some of their earnings from interest rates. If we enter an era of higher interest rates, stocks in the financial sector could end up being solid investments. Let's look at why this is and at five companies that will likely benefit, making their stocks potential investments today.
Banks can earn more interest income amid rising rates
Bank stocks generally welcome higher interest rates, as long as they are introduced gradually. Traditionally, banks make money on the spread -- the difference between the interest income earned on loans they issue and the interest expense paid out on deposits used to fund those loans. That difference, also known as the net interest margin, tends to increase when interest rates rise and decrease when rates fall.
Over the last few decades, banks saw the net interest margin shrink, hurting profitability and bottom lines.
Data source: Federal Reserve Economic Data. Chart by author.
In 2022, this spread improved with higher interest rates, helping banks see solid profits this year. Bank of America (BAC 2.06%), JPMorgan Chase, and U.S. Bancorp (USB 1.48%) are three high-quality banks that benefitted from higher interest rates in 2022. These banks saw net interest margins improve this year, which boosted net interest income.
| Bank |
YTD Net Interest Income Growth |
|---|---|
|
Bank of America |
19.8% |
|
JPMorgan Chase |
20.2% |
|
U.S. Bancorp |
11.4% |
Data sources: Public filings from each financial institution. YTD = year to date.
High interest rates are great for banks, but they can have a drawback. If rates rise too quickly, banks can have difficulty finding borrowers willing to pay those higher rates. Furthermore, if the higher rates slow down the economy, banks may be less willing to make loans to certain borrowers out of concerns about rising default risks.
Despite the short-term risk involved with higher interest rates, banks are happy for rates to stay higher for longer because it will ultimately improve the spread they earn on interest, boosting profits. If remain elevated, you'll want to own some of those high-quality bank stocks as part of a balanced portfolio.
Life insurance companies are happy to escape the ultra-low interest rate era
Unum Group (UNM 0.86%) and Aflac (AFL 0.35%) provide life insurance and other financial products and are another sector of stocks that generally welcome higher interest rates.
Life insurers make money in two ways: premium payments and investment returns they earn from investing those premiums. These companies price their policies based on several factors, and actuaries help them determine the appropriate premium based on an individual's mortality risk. Because there is a period between when the insurer collects the premium and when it pays out claims, life insurers can invest the funds in bonds or other investments to help juice their earnings.
Life insurers make money on the spread between the amount earned on their investments and the amount of interest paid out on products like whole life insurance or annuities with a guaranteed rate of return. When interest rates are low, life insurers' earnings capacity compresses, and they risk not being able to meet their obligations on these products.
Higher interest rates help these companies, which can now invest premiums and generate higher returns, putting them in a better position to offer products to their customers with more attractive guarantees.
Life insurers are highly sensitive to changes in interest rates -- which is likely why companies in this industry performed well during a time when most other companies are getting crushed. Since the start of the year, Unum Group stock is up an impressive 87%, while Aflac is up 11.3%. In comparison, the S&P 500 index dropped roughly 18.8%.
On its second-quarter earnings call, Unum CFO Steve Zabel said the company began to see portfolio yields stabilize after years of decline due to ultra-low interest rates. Its yield on new investments in the second quarter jumped to 4.8%, up from 3.2% during the same quarter last year. In the second quarter, Unum's miscellaneous investment income increased to $57 million from $41 million in the first quarter. Aflac saw its yield on new investments in the U.S. jump from 3.6% last year to 4.1% in the second quarter.
Life insurers had a rough go of it during the low interest rate environment. However, with interest rates rising, these companies will see new investments get a boost, which could improve their profitability in the coming years, especially if rates indeed go higher for longer.
