XLU Utilities Select Sector

As widely expected, the Federal Reserve announced further trimming of $10 more billion in its monthly long-term bond purchases. The latest cut takes the Fed’s monthly asset repurchase program to $55 billion a month. While this was not surprising on the Taper front, the main twist came in the interest rate guidance.

The Fed had so far vowed to keep the short-term rate near zero level. But the chairwoman Janet Yellen said during her press conference that the Fed could start raising interest rates six months after it fully wraps up its bond buying program this fall. Notably, the Fed's benchmark short-term rate has been at the rock-bottom level since 2008.

Following this statement, some economists perceived the time frame of rate rise as mid 2015. Futures traders brought forward their anticipated timing of first interest rate hike to April 2015 from the previous expectation of July.  However, there is a different view as well. According to a Reuters poll, most renowned Wall Street economists continue to see the first rate hike to hit the economy in the second half of 2016.

Whatever be the time frame, the market started to panic on Fed’s comment on rate hike with both bond and equities markets slipping in the key trading session and dollar gaining strength. Previously, it has been noticed that each measured tapering announcement renews concerns of rising rates. This time, alteration in Fed’s interest rate guidance has added to the woes.

Short-term U.S. bond yields spiked the highest in almost three years after Yellen’s comments, with the 10-year Treasury yield jumping 373 basis points to 2.78% (as of March 19, 2014). The rates are expected to move northward in the comings months thanks to acceleration in QE tapering.

Amid such a backdrop, it will be prudent to note the performance of two rate-sensitive sectors to gauge investors’ sentiment regarding the economy’s next move. Apparently, these two sector ETFs might be in trouble in the near term (read: Real Estate ETFs in Focus as Rates Turn Higher).

REIT

REIT is highly interest rate sensitive sector. This is especially true in a high volatility corner of the market known as the mortgage REIT or mREIT space. mREITs generally use a short-term loan to purchase long-term securities and generate revenues from the spread between the two. Therefore, to make profits, these firms need a wide spread between the short and long-term rates.  

These firms are usually highly leveraged and face maximum interest rate risk in the REIT world. This can clearly explains why this sector will underperform if short-term interest rate makes an ascent. Now, REITs are required to distribute 90% of their annual taxable income through dividends which make them high dividend yield vehicles. With the declining income of REITs due to the impact of rising interest rates, the dividend yield will also fall along with returns.

This is why the largest REIT ETF Vanguard REIT Index ETF (VNQ) fell 1.89% following the Fed’s comment in contrast to a 0.53% decline in broader market ETF SPDR S&P 500 (SPY). The biggest iShares Mortgage Real Estate Capped ETF (REM) was down 1.55% at the close of March 19 (read: REIT ETFs in Taper Aftermath: Any Hope for Gains Now?).
 
Utilities

Being a highly safe sector, utilities started the year on a strong footing. While operating metrics remain in place, the sector might suffer in the coming days on its increased dependence on interest rate policy. The sector requires huge infrastructure which places a massive debt burden and the resultant interest obligation on these companies. This leaves the sector with no scope of outperformance in a rising rate environment (read: The Comprehensive Guide to Utility ETFs).

Also, investors look for dividend as a high yield tool. With bond yields preparing to take an upturn, utilities will likely lose its high-yield charm. The biggest utility ETF Utilities Select Sector SPDR ETF (XLU) lost about 1.58% at the close of March 19.

Bottom Line

The cloud over the trimming of the Fed’s bond buying policy is dispersing gradually. With the current unemployment level of 6.7% slowing reaching the Fed’s threshold limit of 6.5%, we expect the Fed to maintain the regular course of QE tapering in the coming months. This might again send the 10-Tresury yield back to the over 3% level.

VNQ and XLU –representatives of REIT and utility sectors – are offering more than 3.50% yield at the current level. If rates keep on rising further, yields will come down and the resultant yields of the ETFs would not be enough to attract yield-hungry investors.

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ISHARS-MTG RE (REM): ETF Research Reports
 
VIPERS-REIT (VNQ): ETF Research Reports
 
SPDR-UTIL SELS (XLU): ETF Research Reports
 
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