Stocks to Benefit from Rising Interest Rates

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Recent economic data in the US has been showing some progress, key sectors like the labor market and even some real estate indicators seem to be experiencing a long awaited improvement. This has produced some increases in long term interest rates. It may be too soon to tell if this process will be sustained in the middle term, but over a long term period interest rates have a lot of upside room.

Investors should keep in mind the fact that interest rates are at record low levels and, if the economy starts showing some sustainable growth, there will be many opportunities to profit from a return to more typical interest rate levels. Before the Federal Reserve starts raising short term rates, long term rates are expected to react to the upside in anticipation of a changing economic scenario.

The process in which long term rates move up before short term rates is called a steepening of the yield curve, and is usually part of the typical interest rates cycle. Sooner or later we will experience such a process, and investors should be prepared to position themselves in some of the companies that benefit from this kind of situation.

Insurance companies are of the sectors that can typically see higher profit margins with increases in interest rates. This kind of business collects a float, which is money that is received from premiums but not yet needed for paying claims. A portion of that money is invested in low risk fixed income securities so it is exposed to low volatility and quickly available for paying insurance claims.

There are some complicated intricacies about how insurance companies manage their assets and allocate capital between securities with different risk levels and time horizon, but higher yields available in fixed income investments mean better profit margins for companies in this industry, which are required to hold a considerable amount of fixed income investments in their portfolio.

Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) may not be considered a pure play on the insurance business, because Buffett´s holding has interests in many other industries. But Berkshire still makes a substantial proportion of its profits from insurance, and the company looks as solid as ever. In September of last year Buffett announced he was considering buying back some Berkshire stock, since valuation looked attractive enough to guarantee such an unprecedented move.

Since that time Berkshire has experienced quite a run from the $65 level to more than $81 currently, but the stock is still below its maximum level above $100 previous to the financial crisis. There are enough reasons to consider a long term position in Berkshire Hathaway regardless of the scenario for interest rates, and a steepening of the yield curve can provide a convenient timing for such a position.

A steepening of the yield curve tends to be a positive factor for banks too, because they borrow money at short term rates and lend it a longer term ones. If you want to follow Buffet´s advice on banks, two notorious candidates could be Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) Keep in mind that Bank of America is probably riskier than Wells Fargo, though.

Buffet wrote in Berkshire´s annual shareholder letter:

“The banking industry is back on its feet, and Wells Fargo is prospering. Its earnings are strong, its assets solid and its capital at record levels. At Bank of America, some huge mistakes were made by prior management. Brian Moynihan has made excellent progress in cleaning these up, though the completion of that process will take a number of years. Concurrently, he is nurturing a huge and attractive underlying business that will endure long after today’s problems are forgotten. Our warrants to buy 700 million Bank of America shares will likely be of great value before they expire.”

There are some important differences between Wells Fargo and Bank of America when it comes to their track record at risk management and their financial performance during the financial crisis. Wells Fargo can be proud of a sound investment policy that has protected shareholders under the worst situations, which is something that cannot be said about Bank of America. Wells Fargo doesn´t need to prove it can correct its past mistakes, while Bank of America needs to keep working in that area for a long time.

Mortgage REITs is another sector that stands to benefit from a steepening of the yield curve because, like banks, these companies borrow money at short term rates and lend it at long term interest rates. Annaly Capital Management (NYSE: NLY) is one of the most popular companies in the sector, and pays a very attractive 14.1% dividend yield. If a steepening yield curve materializes in the scenario, investors could see some considerable capital gains in addition to this juicy dividend.

Rising long term interest rates could have different effects on the economy and financial markets, but some sectors would benefit while others would suffer from such a situation. Being on the right side of economic trends can be an important strategy when trying to generate solid investment returns, it sounds like a good idea to pay attention to the possibility of a steepening yield curve in the middle term.

Motley Fool newsletter services recommend Berkshire Hathaway and Wells Fargo & Company. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, Annaly Capital Management and Wells Fargo & Company and has the following options: short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $29.00 calls on Wells Fargo & Company and short APR 2012 $29.00 calls on Wells Fargo & Company. acardenal has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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