3 ETFs To Sell When Interest Rates Go Up – PFF, VNQ, EEM
For decades, interest rates in the US have been steadily declining. And rates have been at historic lows in the aftermath of the 2008 financial crisis.
The low rates have fueled a boom in sectors of the economy that are sensitive to interest rates. But over the last 30 days, we’ve seen a major reversal in interest rates.
In fact, the interest rate on a 30-year mortgage jumped 21% over the last month. According to research from Bespoke, that’s the biggest month over month spike since at least 1998.
This could be just the leading edge of a much bigger rise in interest rates.
JPMorgan Chase (JPM) CEO, Jamie Dimon, recently told a financial industry conference, “I think you all should be ready, because rates are going to go up.”
Not surprisingly we’re already seeing investors head for the exits on some of the most interest rate sensitive sectors. And if interest rates continue to rise, it will get a lot uglier for these – 3 ETFs to sell when interest rates are going up.
iShares S&P US Preferred Stock Index (PFF)
PFF tracks an index of US preferred stocks. Its 5.27% yield has attracted a lot of money as interest rates dropped lower and lower. It has more than $11billion in assets under management.
It reached an all-time high of $41.09 in early May. But since reaching those highs, PFF has fallen more than 6%. The drop has erased all of the gains it had made this year.
Here’s the thing…
Preferred shares live in a world somewhere between debt and equity. They have the potential for appreciation, but they also pay a fixed dividend.
The fixed dividend is what makes preferred stocks dangerous to own when interest rates are going up. You see, many preferred shares have no maturity date. So they’re technically on the long end of the yield curve. And the long end of the yield curve is hurt the most when interest rates go up.
If interest rates continue to rise, then PFF will continue to fall.
Vanguard REIT Index (VNQ)
VNQ seeks to provide a high level of income and moderate long-term capital appreciation by tracking the performance of a benchmark index that measures the performance of publicly traded equity REITs.
VNQ started off the year by soaring more than 18%. It reached a high of $78.86 on May 22nd. The same day Fed Chairman Bernanke first indicated the Fed could end QE3 sooner than expected. Since reaching the all-time high, VNQ has fallen 12%.
Clearly, Real Estate Investment Trusts or REITs are another investment that’s susceptible to rising interest rates.
How do rising rates hurt VNQ?
Companies that invest in real estate often become a REIT in order to receive special tax considerations. They’re allowed to pay dividends to owners with pre-tax dollars.
But in order to qualify as a REIT, they’re required to distribute 90% of their taxable income to shareholders every year. This unique feature of mandatory distributions of income makes REITs a favorite among income investors.
If income investors can generate income from bonds and treasuries, then they won’t allocate as much money to higher risk investments like REITs.
And don’t forget, REITs are typically highly leveraged. In other words, they use a lot of debt. So when interest rates go up, it will have an impact on the cost of money REITs use to fund their real estate purchases.
iShares MSCI Emerging Markets Index (EEM)
EEM is another ETF that has sold off as interest rates have risen recently. It’s down 9% this month alone.
This ETF is heavily weighted towards the biggest emerging markets like China, South Korea, Brazil, and Taiwan. In fact, the top four countries make up 55% of EEM’s holdings.
Investors are obviously afraid rising interest rates are bad for emerging markets.
For one thing, investors are simply less optimistic about the future. So investors are moving to reduce risk. That means lots of foreign investment in emerging markets is moving to safer havens of developed markets.
According to the World Bank, monetary tightening in developed economies could crimp growth in emerging markets as interest rates rise. It could lower economic output in some countries by as much as 12%!
Obviously, you don’t want to get stuck holding the bag with EEM if economic growth dries up as interest rates rise.
Here’s the upshot…
Interest rates in the US have gone up quickly over the last month. It shocked many investors that expected interest rates to remain low for another year or longer.
It sparked a selloff in many interest rate sensitive ETFs. And if rates continue to rise, you need to sell PFF, VNQ, and EEM now in order to avoid even steeper losses.
Good Investing,
Corey Williams
Category: Dividend ETFs, ETFs, Foreign Market ETFs, Sector ETFs
