Should you bank on rising rates?

Who benefits, who doesn’t?

Q – I need to better understand the impact of interest increases for banks and utilities. Yesterday, I heard an analyst saying that the drop in Canadian bank shares was due to anticipated interest increases. Today, I just saw news saying that JPMorgan profits were helped by higher rates. I am confused. Also, please explain for me what sectors of economy are best positioned to profit of the forecasted interest increases and what sectors will be hurt the most. – Marcel B.

A – Banks normally benefit from higher rates because it allows them to increase their spreads – the difference between the interest they pay on deposits and guaranteed investment certificates (GICs) and the amount they charge borrowers. This is technically known as net interest margin (NIM). Insurance companies also normally benefit from higher rates, for slightly different reasons.

However, this is a broad guideline. Other factors also come into play when assessing individual companies. For example, some analysts believe Canadian banks are carrying more mortgage risk than is reflected in the price, and that has contributed to keeping a lid on share values. Individual banks may also have specific problems – Scotiabank’s exposure to emerging markets in Latin America and Asia has weighed on the stock.

So, while it is true that rising interest rates are beneficial to bank profits, they are not the entire story. You need to look at other aspects of the business as well.

As for utilities, they have always been considered to be interest sensitive for two reasons. First, they tend to have high levels of debt because of the borrowing costs incurred in building corporate infrastructure. Higher rates translate into more interest expense, which lowers profits.

Second, when rates on safe government bonds rise, investors demand higher yields from utility stocks because of the extra risk they carry. That tends to have a downward effect on the share price, which pushes up the yield. A $1 per year payout on a $30 stock yields a 3.3% return. That may be good enough in a period of low interest rates. But when bond rates rise, investors may feel that the same stock must yield 4% to be attractive. That would push the price down to $25, unless the company hiked the dividend.

Again, there can be exceptions. But the fact the S&P/TSX Capped Utilities Index was down 12% in 2018 is a clear indication of the influence of rate increases.

I can’t suggest any sectors apart from banks and insurers that would normally profit from rate increases. One sector that is likely to be hurt is homebuilders, as higher rates make mortgages less affordable. Automakers and parts manufacturers are also vulnerable as rising borrowing costs make car financing more expensive.

Companies with little or no debt are the least exposed to higher costs.

Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder and The Income Investor newsletters, which are available through the Building Wealth website.

For more information on subscriptions to Gordon Pape’s newsletters, check the Building Wealth website.

Follow Gordon Pape on Twitter at https://twitter.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney.

Notes and Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting, or tax advice. Always seek advice from your own financial advisor before making investment decisions.