7 best ETFs for rising interest rates

Investors have plenty of tools to combat higher bond yields. Here are seven of the best ETFs to head off interest-rate risk.

  • By Jeff Reeves,
  • Kiplinger
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Higher Treasury yields have been a buzzworthy topic on Wall Street recently – and the trend has investors seeking out the best stocks and ETFs for rising interest rates.

A year ago, interest rates on the closely watched 10-year U.S. Treasury bond were below 0.8%. But by April, that rate had roughly doubled. And while we saw a bit of a rollback over the summer months, the 10-year T-note is now yielding above 1.6%. The short-term trend is pointing to even higher rates in the months ahead; Kiplinger forecasts the 10-year's yield will reach 1.8% by 2022.

To be clear, these are not "high" rates by any stretch of the imagination. Those who know their market history will recall the 10-year Treasury yield higher than 10% in the early 1980s, rates regularly around 7% in the 1990s and T-notes yielding north of 3% as recently as 2018. By any historical measure, 1.6% is still pretty tame.

That said, the fact we are coming from a lower base means that the percentage change in yields can be quite significant – as evidenced by the fact that rates doubled in a few short months in early 2021. And with swings like this, we can see significant disruptions to certain businesses and asset classes.

Let's explore seven of the best ETFs for rising interest rates. Many of these funds include some of the best stocks for higher rates and allow you to either profit off the trend of rising interest rates or, in an ideal world, at least sidestep any trouble.

Data is as of Oct. 19. Dividend yields represent the trailing 12-month yield, which is a standard measure for equity funds.

Financial Select Sector SPDR ETF

  • Assets under management: $44.7 billion
  • Dividend yield: 1.6%
  • Expenses: 0.12%, or $12 annually for every $10,000 invested

With $45 billion in assets under management, the Financial Select Sector SPDR ETF (XLF) is not just one of the largest funds focused on the finance sector – it's one of the biggest funds out there of any flavor.

Top holdings include the largest financial institutions in the U.S., including investment giant Berkshire Hathaway (BRK/B) and megabank JPMorgan Chase (JPM). Banks make up the lion's share of the fund's portfolio at almost 40%, followed closely by capital markets stocks and asset managers at about 27%.

The phenomenon known as "net interest margin" is one of the big tailwinds created for financial stocks in a rising interest-rate environment. In a nutshell, this is the difference between interest paid on investments or credit that a bank extends and the interest that bank must itself pay to borrow or access capital. A well-run financial firm can continue to increase the rates it charges third parties even while it keeps its own borrowing rates under control – thus leading to bigger profits in the process.

Thanks in part to the recent uptick in the 10-year Treasury yield, many of XLF's holdings have been rallying lately – evidence that this is one of the best ETFs for rising interest rates. The fund is currently sitting on a more than 35% gain year-to-date compared with a slimmer 20% for the broader S&P 500 (.SPX) in the same period.

SPDR S&P Insurance ETF

  • Assets under management: $502.7 million
  • Dividend yield: 2.0%
  • Expenses: 0.35%

Though you will find a smattering of insurance stocks in the Financial Select Sector SPDR ETF, they don't hold as much sway as traditional bank stocks do. However, in a rising-interest-rate environment, the subsector of insurance stocks could be among the very best financial companies out there because of their reliable and cash-rich business model. That's where SPDR S&P Insurance ETF (KIE) comes in.

Consider KIE component Allstate (ALL). The insurance giant took in roughly $8 billion in premiums last quarter alone! Some of this cash will ultimately be paid back out to cover claims, but in the meantime, the firm reinvests that capital in interest-bearing accounts while it waits – and higher rates means a higher return on this capital in the interim.

And given that insurers have to invest this cash from customers in low-risk ways, as opposed to banks that sometimes make more aggressive bets, the result is a highly stable business that just happens to be more profitable thanks to the interest rate environment.

Another reason to look to KIE instead of a broader financial fund when seeking out the best ETFs for rising rates is that it is an "equal weight" fund, with about 50 holdings all targeting a roughly 2% weighting each. If you are a more defensive investor, then the diversified approach and low-risk nature of insurance stocks generally could make this ETF appealing.

Schwab U.S. REIT ETF

  • Assets under management: $6.5 billion
  • Dividend yield: 2.1%
  • Expenses: 0.07%

Another sector that benefits in some way from rising interest rates is real estate. Generally speaking this is a bit counterintuitive, as rising rates tend to increase borrowing costs for everyone – and companies that are taking on big debts to buy properties are going to wind up paying more in this kind of environment.

However, some real estate investment trusts (REITs) actually do quite well amid rising rates. That's in part because the broader driver behind increasing interest rates is normally inflation, and inflation naturally drives up the underlying value of real estate holdings even if it can create debt headaches.

Similarly, rising rates and inflation tend to be hallmarks of growing and healthy economies. In such an environment, landlords can charge more for rent on offices, storefronts and apartments alike.

Enter the Schwab U.S. REIT ETF (SCHH).

This diversified ETF holds the biggest publicly traded names out there, with an average market value of more than $38 billion among its 140 or so holdings. And those holdings include everything from telecom REIT American Tower (AMT) to industrial park giant Prologis (PLD) to more traditional operators of malls, office space and residential properties.

If current market dynamics signal economic growth, then tap into this REIT ETF and reap the benefits from both rising rents and rising rates.

iShares Floating Rate Bond ETF

  • Assets under management: $6.8 billion
  • SEC yield: 0.1%*
  • Expenses: 0.20%

One of the biggest economic disruptions created by rising interest rates isn't just the fact that new mortgages or construction loans are going to cost borrowers more money, but that some existing loans also adjust their rates higher in real time. Variable-rate mortgages, credit card plans and even revolving credit lines for small businesses all tend to be benchmarked to a major interest rate and move higher in kind.

This creates friction for certain consumers and businesses, to be sure. But it also creates a unique opportunity in a fund like the iShares Floating Rate Bond ETF (FLOT). As the name implies, the bonds in this fund aren't fixed in their terms and yield – and as rates in the broader marketplace rise, the bonds that make up this fund will command higher yields, too.

And with the bonds of FLOT coming from top stocks like Goldman Sachs (GS) and Citigroup (C), the holdings of this fund are well-established and reasonably low risk, too.

It's worth noting that right now the yield of this fund is well under 1%, and thus not particularly impressive. But if you're an investor looking for the best ETFs for rising rates and believe yields will rise materially, there could be an opportunity here to both protect your capital and tap into higher distributions down the road.

* SEC yield reflects the interest earned after deducting fund expenses for the most recent 30-day period and is a standard measure for bond and preferred-stock funds.

Vanguard Short-Term Corporate Bond ETF

  • Assets under management: $41.8 billion
  • SEC yield: 1.0%
  • Expenses: 0.05%

If you're primarily concerned with the risk of rising interest rates, the Vanguard Short-Term Corporate Bond ETF (VCSH) is worth a look. That's because this fund is focused only on one corner of the bond market: short-term loans to only the most credit-worthy corporations.

Specifically, the 2,300 or so individual bonds that make up VCSH have an average maturity of just three years. And all of those are via "investment grade" bonds, with more than half of the portfolio including loans to companies with a credit rating of A or better. These include tech titan Apple (AAPL), megabank Bank of America (BAC) and aircraft maker Boeing (BA) to name a few.

Obviously, there is only the smallest of chances that any of those companies go belly up in under three years. Therefore, investors can have a lot more certainty that those debts will be repaid in full.

That admittedly means you don't get paid a big yield because there's not much risk – the current one is only about 1.0%. But what makes this one of the best ETFs for rising rates is that the short-term nature of these bonds leaves them insulated from broader bond-market dynamics.

As rates rise, newer bonds are in higher demand – because, naturally, they offer higher rates of return. That means older bonds from several years ago lose value because investors demand a discount for these lesser-yielding assets. With a very short-term time horizon, VCSH doesn't have to worry as much about this trend as the bonds often mature before significant rate changes can materially alter the value of this fund.

WisdomTree Interest Rate Hedged U.S. Aggregate Bond Fund

  • Assets under management: $220.5 million
  • SEC yield: 1.0%
  • Expenses: 0.23%

The WisdomTree Interest Rate Hedged U.S. Aggregate Bond Fund (AGZD) is one of the smaller funds on this list with only about $220 million in assets under management. It's also one of the more sophisticated offerings for those looking for the best ETFs for rising rates.

This WisdomTree fund deploys "short" positions in Treasury securities, meaning it's actually making a small bet against the principal value of bonds. This is in order to hedge against the aforementioned phenomenon where bonds lose value as rates rise. This is not to say AGZD is betting on a big move down in the bond market as its way to make you money, just that it hedges its bets to theoretically zero out any of these risks.

This allows AGZD to take a truly diversified, or "aggregate," approach to the bond market. Of more than 2,000 individual bonds, the average maturity is a little over 14 years. It also owns a small amount of higher-risk or "junk" bonds to boost the overall yield and holds both corporate and government bonds to give you a fully diversified mix.

There is no risk-free investment, of course, but AGZD does offer a way to minimize some of the disruptions you may see from a rising rate environment.

iShares TIPS Bond ETF

  • Assets under management: $34.6 billion
  • Real yield: -1.4%*
  • Expenses: 0.19%

Back to the root causes of higher interest rates, this next fund provides investors with a way to protect themselves from broader market dynamics that could create disruptions to their existing portfolio.

The iShares TIPS Bond ETF (TIP) is focused on U.S. Treasury Inflation-Protected Securities, or TIPS. These special bonds actually increase in principal value along with the rate of inflation – ensuring your investment isn't eroded here as it might be in other assets.

It works because TIPS bonds are benchmarked to the consumer price index, a widespread measure of how fast prices are rising and one a metric watched by policymakers at the Federal Reserve to measure the rate of inflation.

Of course, there's no such thing as a perfect way to zero out risk. Perhaps obviously, these bonds will see an increase in value when inflation is hot, but you might be stuck with an asset that doesn't really do anything when prices are stagnant or only slowly rising.

Right now the SEC yield is an impressive 3.2%, and the principal value of TIP has actually gone up slightly in 2021, even as some other bond funds have struggled. However, the real yield, which is adjusted for inflation, is actually -1.4%.

And in the early 2010s, when there was also a lot of talk about the threat of inflation that never materialized, investors piled into TIPS bonds to accept yields that were slightly negative on the expectations rapid inflation would more than make up for it in the long run. When it didn't, they were stuck in a very bad investment indeed.

TIPS can be a great profit center if and when inflation remains real and persistent. But just make sure you understand the risk if that doesn't transpire.

* Real yield is adjusted for inflation.

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