While the Federal Reserve left interest rates unchanged at the latest meeting, investors increasingly speculate that rate hikes are on the table in 2026. Projections from the Federal Open Market Committee show nine of 18 policymakers now project at least one interest rate increase by the end of 2026, bringing the median estimate for year-end interest rates from 3.4% to 3.8%. With the Federal Reserve signaling that future rate hikes may be on the horizon to combat persistent inflation, investors are increasingly looking for products to position their portfolios against interest rate volatility.
Key Takeaways
- Short-duration and floating-rate bonds serve as effective tools to mitigate interest rate volatility. Floating-rates adjust to changing benchmark rates and proceeds from short-duration bonds at maturity can be reinvested at higher yields.
- Asset classes such as financials and value stocks historically demonstrate greater durability in rising-rate environments through resilience to higher borrowing costs and emphasis on stable cash flows and fundamentals.
Systematic Approach to Rate Hikes
For those looking for a systematic approach to combat interest rate volatility across equity markets, the ProShares Equities for Rising Rates ETF (EQRR) and the Fidelity Dividend ETF for Rising Rates (FDRR) are designed to help investors navigate periods of rising rates.
EQRR aims to outperform traditional U.S. large cap indexes when interest rates climb. The fund tracks the Nasdaq US Large Cap Equity Rising Rates Index, which identifies the five sectors with the highest correlation to the 10-Year U.S. Treasury yield over the previous 36 months. Typically, this includes sectors such as energy and financials, which have demonstrated resilience to rising rates.
The sector with the highest correlation receives a 30% portfolio weight, followed by 25%, 20%, 15%, and 10% for the remaining four sectors. Within each of the five sectors, the fund selects the 10 stocks with the highest correlation to rising Treasury yields. The top stocks are then equally weighted within their sector.
Dividend-paying stocks often see price declines in a rising-rate environment, as investors rotate capital towards fixed-income markets with higher risk-free yields. FDRR combats this by targeting U.S. large- and midcap companies that pay strong growing dividends, while screening specifically for companies with a positive correlation to rising 10-year Treasury yields.
Tracking the Fidelity Dividend Index for Rising Rates, the fund primarily invests in cyclical sectors such as information technology, financials, energy, and infrastructure. These can better absorb higher borrowing costs compared to sectors heavily reliant on debt financing, like REITs and utilities.
Floating-Rate Bonds and Senior Loans
Floating-rate bonds and senior bank loans have variable coupon payments that adjust periodically in response to benchmark interest rates. When interest rates rise, the yield on the underlying assets goes up simultaneously, mitigating a majority of the duration risk that comes with investment in fixed-rate and longer duration bonds.
The iShares Floating Rate Bond ETF (FLOT) provides exposure to investment-grade corporate bonds with floating interest rates by tracking the Bloomberg US Floating Rate Notes (<5 Y) Index. The fund targets maturities ranging from one month to five years, providing a conservative tool to capture rising yields.
The Invesco Senior Loan ETF (BKLN) tracks the S&P/LSTA US Leveraged Loan 100 Index. This index is designed to measure the market-weighted performance of the 100 largest institutional leveraged loans. The fund primarily invests in below-investment-grade loans, offering higher yields in exchange for lower credit quality.
For investors seeking actively managed exposure to floating-rate securities, the T. Rowe Price Floating Rate ETF (TFLR) invests a majority of assets in a diversified portfolio of below investment-grade floating-rate loans across 200 to 300 issuers.
Ultra-Short-Duration Bonds and Cash Equivalents
Longer duration bonds historically see price declines in rising rate environments. Meanwhile, ultra-short duration bonds, with maturities of just a few months, allow investors to reinvest capital into higher-yielding bonds as the short-term bonds mature. This protects investors from a substantial amount of the interest rate volatility seen in longer duration fixed income investments.
Funds such as the iShares 0-3 Month Treasury Bond ETF (SGOV) and the State Street SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) provide low cost capital preservation in higher-rate environments, typically offering a higher yield than traditional savings accounts.
SGOV tracks the ICE 0-3 Month US Treasury Bill Index, investing in U.S. Treasuries with maturities of three months or less, while BIL tracks the Bloomberg 1-3 Month US Treasury Bill Index. The funds rebalance monthly, reinvesting proceeds into new short-term bills, while also distributing monthly income based on the interest accrued within the portfolio.
Financial Sector Equities
Financial companies tend to be one of the few equity sectors that can benefit from rising interest rates. Higher rates allow banks and lenders to expand their net interest margin (the spread between the interest paid on deposits and the interest earned from loans).
Smaller regional banks often benefit significantly from rising interest rates, as they are heavily reliant on traditional lending and deposit-taking compared to large global banks, which have investment banking, trading, and other sources of non-interest income. The State Street SPDR S&P Regional Banking ETF (KRE) provides equally-weighted exposure to these smaller regional banks by tracking the S&P Regional Banks Select Industry Index.
For broader exposure to financial equities, funds such as the State Street Financial Select Sector SPDR ETF (XLF) provide exposure to large-cap U.S. financials within the Financial Select Sector Index. The fund distributes investment across all market capitalizations to capture systematic growth in the financial sector, while also mitigating concentration risk.
Value Over Growth
Rising rate environments tend to disproportionately affect growth stocks as the companies derive valuations based on expected future profits. When interest rates rise, the discount rates rise simultaneously, reducing the present value of future earnings. Conversely, established value stocks with strong current cash flows, stable balance sheets, and lower P/E ratios historically are less sensitive to interest rate hikes.
Funds such as the Vanguard Value ETF (VTV) and the iShares Russell 1000 Value ETF (IWD) provide exposure to large-cap U.S. companies perceived to be undervalued by the market relative to comparable companies. VTV tracks the CRSP U.S. Large Cap Value Index, while IWD follows the Russell 1000 Value Index.
Originally posted on ETF Trends
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