Recently, much of my work had focused on the role interest rates play in the current state of financial markets. While the Federal Reserve has raised rates, the anticipated upward movement of real rates, mainly in bonds, has yet to solidly materialize.
Rising rates will affect financial sector stocks in different ways. Banks, especially regional banks, tend to preform better if rates are rising. Rising rates are indicative of an improving economy. A healthier economy points to rising consumer demand and business expansion. Regional bank margins usually improve with higher loan demand and accompanying higher rates.
Put simply: banks can charge more therefore they make more.
It’s rare that financial sector stocks can operate independent of interest rates. However, there are a select few that are good beds regardless of what rates are doing. And that's what I want to focus on today...
Business Development Companies -- Over the last decade, these entities, also known as BDCs, have stepped in and become the nation's middle market business lender. During the financial crisis, as traditional banks backed away from lending to small and mid-sized businesses, BDCs filled the gap thanks mainly to their ability to tap capital markets, charge a bit more, and structure creative deals (often with an equity component).
While rising interest rates can cause borrowing costs to go up, BDCs typically charge above market rates due to the enhanced risk they are taking. The businesses that borrow from BDCs are used to this. If rates are lower, BDC margins are better because of their ability to lend at the higher rate. The equity component involved with BDC lending also creates additional value. In the event of a business being acquired as the BDC typically profits from any transaction.
Two publicly-traded BDCs on my radar are Hercules Capital (Nasdaq: HTGC) and Apollo Investment Corporation (Nasdaq: AINV).
Headquartered in Silicon Valley, HTGC’s portfolio focuses on emerging technology, renewable energy, and biotech companies. Shares trade around $13 and pay a hefty 9.3% yield.
Apollo's portfolio is a bit more diversified, covering the spectrum of everything from telecom equipment to restaurant chains. Shares trade around $6 with a 9.4% yield.
REITs -- Fluctuating interest rates can act as a regulating mechanism for real estate investment trusts, or REITs. Again, like BDCs, it all comes back to borrowing costs.
Higher rates, evidence of a growing economy, gives landlords the justification to raise rents which their tenants can absorb thanks to better business conditions. Lower rates during a sluggish economy can help well-run companies expand cheaply, gaining market share in order to position themselves for the rebound.
However, the REIT I’ve found particularly interesting moves independently of the traditional REIT model.
New Residential Investment Corporation (NYSE: NRZ) has an extremely unique portfolio: 76% of NRZ's portfolio is comprised of servicer advances and excess mortgage servicing rights (MSRs). These are portions of a mortgage loan that are used to pay and cover payments to the party that oversees servicing that mortgage (billing, collecting payments, etc.).
For example, a stated interest rate on a mortgage might be 4.38%. 4.23% will be the actual interest paid to the mortgage holder while 0.15% goes to the servicer. These portions of the mortgage are often "stripped" from the mortgage and sold off as well. Typically, they have a better place in line in the event of default in that the servicer must be paid whether the loan is performing or not. This is a function that is not dictated by whether interest rates are high or low. It’s a necessary cost. NRZ shares currently trade at around $16 and yield 12.2%.
The CBRE Clarion Global Real Estate Fund (NYSE: IGR) is a StreetAuthority staple and fits with my previous description of how REITs can behave well in any rate environment. A well-seasoned closed-end fund (CEF), IGR holds a broad, global portfolio of publicly-traded REITs, weighted 53% in commercial real estate and the remainder spread amongst mortgage, medical and industrial. Again, geographic and sector diversification provide a good defense. IGR shares trade at around $7.74 with a 7.7% dividend yield.
Risks to consider: During market corrections, the baby can get thrown out with the bathwater. In the energy space, pipeline companies, in theory, are merely concerned with moving products from point A to point B. Oil prices, realistically, shouldn’t have that much influence on the sector. However, when energy shares go down, the market usually takes a shoot first ask questions later. Investors should always consider this phenomenon. As John Maynard Keynes said: "The market can stay irrational longer than you can stay solvent."
Action To Take: As a basket, these stocks throw off a yield of nearly 9.7%. Given the current handwringing concerning whether real rates will rise and fall, it makes sense to get paid above market rates by financial stocks that can perform well in both types of rate environments.
Disclosure: I own shares of HTGC, AINV, and NRZ in personal, family and client accounts.
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