What Assets Do Well With Rising Interest Rates?

Rising interest rates signal a shift in the economic landscape, creating uncertainty for investors. While challenging for some traditional investments, this environment also presents opportunities for specific asset categories. Understanding which assets perform favorably during periods of increasing rates can help adapt investment strategies. This article explores various asset classes that tend to perform favorably when interest rates rise.

Economic Context of Rising Rates

Rising interest rates signify a central bank’s efforts to manage economic conditions, often in response to inflation or robust economic growth. Central banks increase benchmark rates to temper price increases and stabilize the financial system when the economy expands and inflation risks emerge. This action directly influences borrowing costs across the economy, impacting consumer loans and corporate debt. Higher rates can slow economic activity by making credit more expensive, affecting corporate profitability and consumer spending. This environment also pressures fixed-income investments like traditional bonds, as their existing lower yields become less attractive compared to newly issued, higher-yielding alternatives.

Asset Categories That Benefit

Financial sector stocks, particularly banks and insurance companies, improve profitability in a rising interest rate environment. Banks benefit from an expansion of their net interest margin (NIM), the difference between interest earned on loans and interest paid on deposits. As rates climb, banks can increase interest charged on loans faster than interest paid on customer deposits, leading to a wider margin. Insurance companies also benefit because higher interest rates increase investment income from their large portfolios of invested premiums. These companies hold substantial reserves in conservative, interest-bearing assets, and rising yields enhance returns on these investments.

Floating-rate securities perform well when interest rates rise. Unlike fixed-rate bonds, these securities have interest payments that adjust periodically based on a predetermined benchmark rate, such as the Secured Overnight Financing Rate (SOFR) or the Prime Rate. As the benchmark rate rises, the interest payments received by the investor also increase. This mechanism reduces interest rate risk, as the security’s yield automatically adjusts to reflect current market conditions. Floating-rate notes and leveraged loans are common examples, providing investors with a yield that can keep pace with rising rates.

Value stocks, representing companies trading at lower prices relative to their fundamental value, are less sensitive to rising interest rates compared to growth stocks. Growth stocks are valued based on expectations of future earnings, and higher interest rates increase the discount rate applied to these distant cash flows, reducing their present value. In contrast, value stocks have more stable, present-day earnings and are less reliant on long-term growth projections for their valuation. This makes them more resilient when borrowing costs increase and future earnings are discounted more heavily. Companies in traditional sectors like energy, materials, and industrials often populate value indices and see improved performance.

Certain types of real estate also perform favorably, particularly those with shorter lease terms or strong pricing power. Commercial properties, such as multi-family housing or certain retail spaces, allow landlords to adjust rents more frequently to account for inflation and rising operational costs. This ability to pass on increased expenses helps maintain or grow net operating income, even as financing costs rise. In periods of rising rates, homeownership can become less affordable, increasing demand for rental properties and supporting rent increases and occupancy rates.

Key Considerations for Investors

Understanding the distinction between nominal and real interest rates is key for evaluating asset performance. A nominal interest rate is the stated rate, while the real interest rate accounts for inflation, representing the actual purchasing power of returns. If inflation rises faster than nominal rates, real returns can erode, reducing investors’ purchasing power.

For fixed-income investments, duration measures a bond’s sensitivity to interest rate changes. A bond with a longer duration experiences greater price fluctuation for a given change in interest rates compared to a shorter-duration bond. When rates are rising, shorter-duration bonds are less affected by price declines, making them a consideration for managing interest rate risk within a portfolio.

Diversification is a fundamental principle, even when focusing on assets that may benefit from rising rates. Spreading investments across various asset classes, sectors, and geographies mitigates risks from focusing too heavily on one area. This approach provides a more balanced portfolio equipped to navigate different economic conditions and market shifts.