With the intense focus on the Federal Open Market Committee's interest-rate decision Wednesday, the market may be missing the bigger picture.
The most commonly used pricing benchmark for commercial loans is not the fed funds rate, but three-month LIBOR. Without much fanfare, LIBOR has steadily risen over the past year, and now sits at a 52-week high of 2.27%. The three-month LIBOR is within two basis points of the yield on the 2-year Treasury today, and that is not a natural state of affairs.
There can be "mini-inversions" in different segments of the yield curve without having a classical inversion. According to Bespoke Research, the bond markets have not experienced a classical inversion -- yield on the 10-year U.S. Treasury Note lower than the yield on the 3-month Treasury Bill -- in 2,767 trading days, a record gap.
If the Fed allows the yield curve to invert, as it last did with disastrous results in 2007, I will not be owning any stocks. Let's assume that's not going to happen, however, and find some winners from higher short-term rates. Pay attention to the modifier there: short-term. I am not writing a column about "winners from higher long-term rates" because the bond market bulls are just too darn persistent.
When the 10-year crosses 3% I will start to pay attention, but that yield is down to 2.82% today, and I am not going to try and wait out those bulls.
So, the knee-jerk reaction when rates rise is to buy the financials. That really hasn't worked in 2018, though, since the Financial Select Sector SPDR ETF (XLF) is almost to the penny where it finished 2017. That's basically in line with the S&P 500, which after today's bloodbath is now down a couple ticks thus far year-to-date.
I don't invest for my clients to match the performance of the indices. I do it to create relative outperformance, or alpha, and that is why stock selection is so important. A rising three-month LIBOR rate really doesn't help JPMorgan's (JPM) core profitability, since JPM's funding costs rise along with increased prices for loans.
What really drives profitability for a money-center bank is the spread between short- and long-term rates, and with the 2-10 spread at 55 points I can't get too excited about JPM. It's been a great long-term hold, and I am not selling it because the market is finally realizing that Facebook (FB) is not a force for good, but I am not initiating new positions in the banks, either.
To play rising LIBOR, I use a more targeted approach and aim for the companies that really benefit: business development companies. BDCs are at the forefront of the economy and the companies to which they lend are often smaller and less-price sensitive than the average corporate customer for JPMorgan.
BDCs (most are registered under the 1940 Act, so are technically BDC-RICs) will be the first beneficiaries of rising rates, and some of them specialize in holding floating-rate notes, so that's an added benefit and a boost to operating margins.
My favorite BDC-RIC now is PennantPark Floating Rate Capital (PFLT) . As the name implies PFLT was created by the managers of PennantPark Investment Corp. (PNNT) specifically to own floating-rate loans, and those are a great investment in this rate environment.
Another name, and one I have mentioned in prior Real Money columns is Newtek Business Services (NEWT) . You may have seen Newtek's CEO, Barry Sloane (an alumnus of Donaldson, Lufkin & Jenrette, as am I), standing next to a pile of cash in NEWT's ubiquitous television commercials. That on-the-ground business tactic is what makes NEWT stock such a good buy in an environment in which the cost of money (which is by definition what interest rates really are) is rising.
So, ignore the folks on CNBC yelling about the yield on the 10-year and add PFLT and NEWT to your portfolio to play raising rates from an offensive perspective, not a defensive one.