Places to Consider Riding out the Rate Regime Change

Despite multiple signs that global growth remains sluggish, bond yields recently hit fresh highs for the year. The yield on the 10-year Treasury rose sharply last week from 2.12% to 2.4%, as prices correspondingly fell, and U.S. real yields are now up by more than 50 basis points since mid-April.

Bond yields’ recent ascent is partly due to expectations for a Federal Reserve (Fed) interest rate liftoff shifting to September. Technical factors and the selling of European debt are also to blame.

Looking forward, even if you assume bond yields settle down, probably somewhere in last fall’s range of 2.2% to 2.6% for the 10-year Treasury note, this moderate year-to-date rise is still likely to inflict significant damage on parts of the market.

As I write in my new weekly commentary, “Staying Grounded as Rates Drift Higher,” parts of the market sensitive to rate increases have proved to be vulnerable. As such, investors may want to consider two less obvious places to ride out the rate regime change: financial and health care stocks.

It appears that some of the classic “safe haven” plays may not be as safe as they seem. In addition to long-duration Treasuries, these classic “safe havens” include high-yielding defensive equities like utilities, as well as precious metals, both of which are sensitive to changes in real interest rates. For instance, last week U.S. utilities, usually viewed as a less risky sector, were down 4%, dramatically underperforming the market. The sell-off was a function of investors re-pricing the sector in accordance with higher rates.

Precious metals were another casualty of last week’s bond market rout, with gold and silver down 1.5% and 3.5%, respectively. Their weakness relative to stocks, and even other commodities, was consistent with the historical pattern: These assets are very sensitive to rising real rates.

With these classic safe havens providing little protection, the financial and health care sectors may be worth considering. Banks are a potential beneficiary of higher rates, and despite broader stock market weakness, the S&P 500 financial sector was actually up last week. For investors looking at more defensive parts of the market, health care stocks, utilities or telecommunications could be considered. Unlike the latter two, health care has generally performed relatively well in a rising-rate environment.

Sources: Bloomberg, BlackRock

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

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