Bond investors are getting walloped by higher interest rates, but they aren't the only ones feeling the pain.
While the S&P 500 (.SPX) notched a 4% return in May — its seventh straight monthly gain — some sectors tumbled along with bond prices. Utilities fared worst, losing 7.7%. Other sectors that lost ground? Consumer staples, telecom stocks and REITs.
These so-called defensive parts of the market have two things in common: healthy dividend yields and stable earnings that sent the sectors soaring to record highs and valuations. Last month's sell-off may reflect profit-taking after such a steep climb.
At the same time, rising bond yields pose a challenge to big dividend payers — making them less compelling for income investors. "Bonds serve as competition for dividend-yielding stocks," says strategist Ed Yardeni, head of investment advisory firm Yardeni Research. "With yields going back up, dividend-paying stocks look less attractive."
Yet rising rates aren't bad for all stocks. If investors are selling bonds because the economy is improving and inflation expectations are picking up, that could make stocks more attractive overall.
For example, large- and small-cap stocks have returned more than 13%, on average, when 10-year Treasury yields rose roughly 1 percentage point over a 12-month period, according to research from Fidelity Investments. Since 1962, the S&P 500 has gained an average 7.5% over a six-month period after the start of a rising-rate cycle, according to research from investment firm Birinyi Associates.
If rates are rising because the economy is improving, cyclical sectors like energy and technology may outperform, says Yardeni. Companies with a history of strong dividend growth also look compelling since their yields should increase with earnings, keeping them competitive with bonds. Other areas to consider include financials and consumer discretionary stocks — both of which could benefit from a stronger economy.
If you own an S&P 500 index fund you already have exposure to these sectors; adding more may increase your risk of trailing the market. Indeed, investing in some of these market niches may backfire if economic growth weakens and interest rates fall, shifting momentum back to defensive stocks.
Also, individual stocks can trail the market for long stretches — one reason you may want to stick with diversified ETFs or funds. If you do buy stocks or ETFs, consider investing gradually over a period of weeks or months to reduce your risk. And make sure that any stocks or ETFs you buy don't raise your portfolio's overall risk above your comfort level.
Here are a few stocks and ETFs to consider, based on our research and interviews with money managers and investing professionals. However you go, you should consult a financial adviser or do your own research before investing.
Banks and payroll services
With short-term interest rates near zero, banks and other lenders can borrow money for practically nothing and lend it out at higher rates. And if longer rates keep rising, financial company profits on the "rate spread" should improve, says John Kozey, senior analyst with Thomson Reuters.
While the Federal Reserve controls short-term rates — and has pledged to hold them down for some time — it has less sway over longer-term market rates, which have been rising despite the central bank's purchases of $85 billion a month in government-backed debt.
The financial sector has other tailwinds too, including an improving housing market and lower default rates on mortgages. And the sector looks cheap, says Kozey. Using adjusted earnings estimates that try to correct for Wall Street analyst biases, he figures the sector will grow earnings per share at a 10.7% annual rate over the next five years, well above the 5.3% rate the market expects.
The Financial Select Sector SPDR Fund (XLF) offers diversified exposure to financial stocks. The $13.9 billion ETF tracks an index of large banks including JP Morgan Chase (JPM), Wells Fargo (WFC) and Bank of America (BAC), and includes other finance companies such as Berkshire Hathaway (BRK/B) and real estate firm Simon Property Group (SPG). Morningstar analyst Robert Goldsborough describes it as an "effective tool" for investors who want to overweight financial stocks in a diversified portfolio.
The downside: The ETF is almost twice as volatile as the S&P 500, according to Morningstar, and yields 1.4%, slightly below the S&P's 2% yield.
Payroll services companies, which manage payrolls for companies and local governments, may also benefit from rising rates.
These companies withhold taxes from employees and earn interest on the cash before it's paid back to the government. The income they earn off that "float" has been exceptionally low as rates have been near zero, pressuring their profits. But if rates rise gradually, this income stream should rise over time, boosting the bottom line, says analyst David Togut with investment bank Evercore Partners in New York.
Payroll firm Automatic Data Processing (ADP) looks compelling, he says. An increase in rates across the yield curve of a quarter percentage point would boost its earnings by a penny a share, he estimates.
The Roseland, N.J.-based company is rolling out its strongest suite of products and technologies in two decades, he adds, and is winning customers from competitors in the small business market. He figures the stock is worth $77 a share, up from around $68 recently. It yields 2.5%.
The downside: ADP trades at 22 times estimated earnings for fiscal 2014, a steep premium to the S&P 500. The stock could decline if employment reports are weaker than expected.
These trends could also pay off for Paychex (PAYX), a Rochester, N.Y., payroll company that's doing a "solid job" of controlling expenses and is starting to see benefits from changes in its sales force and technology, according to a note by analyst Timothy McHugh of investment bank William Blair, who recommends the stock. The dividend yield is a bit higher than ADP at around 3.5%, and the company has boosted its payout an average 10% a year over the last five years.
The downside: Paychex trades around 22 times forward earnings, and its valuation is around the midpoint of its range over the last three years, according to Raymond James analyst Michael Baker, who has a hold rating on the stock. Weaker employment figures would likely pressure the stock.
Media and retail
Higher rates boost borrowing costs for consumers. But if rising rates coincide with stronger economic growth, a broad range of companies tied to discretionary consumer spending could see benefits.
S&P Capital IQ analyst Tuna Amobi has an "overweight" recommendation on the sector, maintaining that stock valuations and earnings look compelling. The sector is projected to generate 15.9% annual profit growth over the next five years, the highest rate in the S&P 500. And it trades 20% below the market's average price-to-earnings growth ratio.
The iShares U.S. Consumer Services ETF (IYC) holds an array of stocks tied to consumer spending, including Home Depot (HD), Ford (F) and eBay (EBAY). The ETF can work in a diversified portfolio for investors looking to "bulk up their exposure to the consumer," Morningstar analyst Goldsborough wrote in a note. Another plus: the ETF is less volatile than rivals.
The downside: The ETF could slump if consumer spending weakens. Its 0.47% expense ratio is higher than the Consumer Discretionary Select Sector SPDR (XLY), which has an expense ratio of just 0.18%.
If you're willing to take a bit more risk, some individual stocks may worth considering. S&P Capital IQ has "strong buy" recommendations on consumer names such as CBS (CBS), Coach (COH) and Disney (DIS).
CBS looks "well positioned" to benefit from the economic rebound, Amobi recently noted, and the stock could rally from a spinoff of its outdoor advertising business and the potential to boost share buybacks.
Disney is generating solid growth from its TV, theme park and film businesses, according to Amobi, and it's made some relatively compelling acquisitions (Marvel and Lucasfilm) to boost profits. The company's capital spending seems to be tapering off, he adds, leaving more cash for share buybacks or dividends.
Coach, meanwhile, is projected to grow sales from $5.1 billion in fiscal 2013 to $5.4 billion in fiscal 2014, boosted by new store openings and an expanding product line, according to a report by S&P Capital IQ analyst Jason Asaeda. He expects profit margins to edge higher and notes the stock's price/earnings ratio of 16 is below its 10-year average of 20.
The downsides: All three stocks are more volatile than the market and could tumble if the companies miss earnings forecasts. They each trade near their 52-week highs and may not have much upside in the near term.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.