The Federal Reserve has officially ended its bond-buying program. That doesn't mean short-term interest rates will rise, though -- not until the Fed determines that the economy is strong enough. Still, if all goes well, short-term rates will probably begin to increase sometime next year.
Long-term rates may be a bit more unpredictable, however, and could edge upward more quickly in the absence of quantitative easing.
What's an investor to do? Despite the uncertainty, it's best to be prepared. We asked three Foolish financial writers what they thought would be prudent moves in case of a rate increase, and here's what they had to say.
Life insurers were among the first to take a hit from the financial crisis, when the S&P 500 insurance sub-index began spiraling downward exactly seven years ago this October.
Like its peers, Prudential has seen its investment income suffer from the post-crisis, low-interest-rate environment. Taking customers' premiums today and investing them for payout years in the future involves investing in long-term assets -- namely, bonds.
With the industry's benchmark, the 10-year Treasury note, moving no higher than 3.06% over the past 52 weeks, it isn't hard to imagine Prudential's pain.
A gradual rise in rates would be a boon for life insurers in general, increasing credit spreads and bulking up reserves. For Prudential, that scenario would be extra sweet, because of its new business segment: taking on pension investment and administration for major U.S. companies, like Motorola.
Pensions, of course, are also long-term investments that stand to gain from a rise in interest rates. Prudential also has accepted responsibility for the pensions of General Motors and Verizon Communications. When interest rates finally do begin to rise, I think Prudential is one company poised to take full advantage.
Rising long-term rates are generally good for mortgage REITs like Annaly Capital Management because, assuming that short-term rates hold steady, it expands their interest rate spread -- though it's also worth noting that rising long-term rates have a concomitant effect on the value of a company like Annaly's portfolio of mortgage-backed securities.
By contrast, rising short-term rates are generally better for the typical commercial bank. That's because the lion's share of most commercial bank loan portfolios is indexed to either the LIBOR or Fed Fund rates, while often a large portion of their funding base is made up of noninterest-bearing demand deposits. Thus, as short-term rates rise, their interest rate spread widens.
With this in mind, if we're talking about rising long-term rates, then I wouldn't buy anything, as I don't like the business model of most companies that arbitrage interest rates without a stable funding source like retail deposits. On the other hand, if we're talking about rising short-term rates, then I'd stick with a lender with an impeccable record of success, such as U.S. Bancorp, Wells Fargo, or M&T Bank.
It's dangerous to assume that any insurer will inherently make more money if interest rates rise. In the short run, rising rates should lead to fatter profits. But if rates stay high, insurers will begin pricing policies with higher rates in mind, and competition will eventually force insurers to lower prices to attract customers. The lower prices will be afforded by the higher returns earned on their floats.
I like Chubb for two reasons. First, a majority (roughly 56%) of its portfolio is held in securities that won't mature for five years or more. So it's more exposed to long-term interest rates than other companies, and long-term rates should rise the fastest in a rising-rate environment. Secondly, Chubb has shown over the decades that it has pricing discipline. If its competition starts pricing irrationally, Chubb simply doesn't write new policies. Thus, I expect that Chubb will price its policies rationally and retain most of the additional income that will come from its investment portfolio should rates go up.
Finally, Chubb is in a category of its own in the world of dividend stocks. It has increased its dividend for 48 years in a row, something few companies, and even fewer insurers, have managed to do.