How to Hedge Against Rising Rates

 | Apr 18, 2013 | 2:30 PM EDT
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If you ask investors and analysts what they view as the biggest threat to the U.S. stock market today, I'd suspect the most common answer would be interest rates – specifically, rising interest rates. Higher interest makes less risky assets more attractive and riskier assets less attractive.

The next question focuses on how to best protect against the seemingly inevitable future rise in interest rates. For this, you will get a mosaic of answers ranging from complex derivative trades to shorting fixed income securities to simply sitting on more cash.

I have another suggestion: Own shares in the largest consumer banks as a hedge against rising interest rates. It's simple, clean and likely to be very effective.

The biggest banks are sitting on hundreds of billion dollars worth of deposits. Many folks still feel better at night knowing they have money in the bank as opposed to out in the stock market. So the deposits are sticky. Technically, deposits are liabilities to a bank but they are actually assets. Deposits fund loans and lending is how the big consumer banks make their money.

Today, banks are getting to hold the deposits at virtually no cost to them in today's interest rate world. The main costs are in account maintenance, but many of those are borne by the account owner. When interest rates go up, those deposits will be able to fuel higher interest rate loans. Deposit rates won't go up as much because banks will be able to offer consumers perks, such as free checking accounts that pay low rates. So higher rates will increase the spread that the banks earn from lending compared to what they pay on deposits.

Bank of America (BAC) currently sits on $1.1 trillion of deposits against $900 billion in loans. Those deposits are an unbelievable "asset" to have going forward. According to BofA, a 1% increase in interest rates would positively affect its bottom line by $4 billion to $5 billion dollars. Rising rates will fuel BofA's earnings. Wells Fargo (WFC) is benefiting  for precisely the same reason (and this is why Warren Buffett has been furiously buying the stock for the past several years). Citigroup (C), which has more than $800 million in deposits, is also a big winner when rates start trickling higher.

Talk to any traditional banker and they will tell that deposits are the name of the game -- why do you think you get more perks at a bank when you have larger balances? Deposits are the raw materials that fuel growth. In this case, dare I say, bigger can be better. Consumers who want to preserve their cash park it in a bank. Investors who also want to protect their portfolios, should also park some of their cash in bank stocks.

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