With the Federal Reserve hiking interest rates on Wednesday and the chances of further hikes increasing, the likelihood is that we will see a raising interest rate environment for years to come. It will not be a smooth increase and many unexpected consequences will occur, but a logical question is "Where do we look to benefit from higher rates?"
Typically, banks and financial services are part of the first group that comes to mind. Banks make money by acquiring cash shorter term at lower rates and lending it longer term at higher rates. When rates go up it is positive for banks because longer-term rates tend to rise faster than shorter-term rates.
Unfortunately for bankers, that is currently not the case. What we are seeing now is a flat yield curve, where the spread between long- and short-term rates is quite small. This limits profits for banks and can be a negative if the yield curve inverts.
The Fed primarily influences interest rates in the short term while market forces determine longer-term rates. Once the market starts to push longer-term rates up at a faster pace, banks then will benefit. But right now the opposite seems to be occurring, with the risk of an inverted curve building.
Another traditional beneficiary of higher interest rates is precious metals. Gold and silver are generally viewed as safe havens as inflation takes hold, but the strength in the dollar has undermined this traditional relationship. As the dollar strengthens, gold, which is denominated in other currencies, declines in value.
This dynamic is likely to change as central banks around the world become less accommodative, but at present the higher rates in the U.S. are attracting foreign investors and are keeping the dollar strong and gold weak.
One industry that would seem to be hurt by higher rates in a flat yield curve environment is mortgage lending, but there is a subset of this industry that services these loans that actually benefits as the level of mortgage refinancing declines.
New Residential Investment Corp. (NRZ) invests in Mortgage Servicing Rights (MSRs). MSRs are the contractual right to service mortgages that are sold by lenders to another party. The purchaser of the MSR is paid a fee for collecting monthly payments, handling escrow agreements and all the other tasks associated with mortgage loans.
The value of MSRs is largely a function of the length of their terms. The longer the mortgages are outstanding, the greater the cash flow and the more valuable the MSR.
When interest rates are rising there is less refinancing of mortgages, which makes the MSRs more valuable. Therefore, a company such as NRZ, which has more than $500 billion in MSRs, benefits as interest rates rise and its MSR portfolio goes up in value.
NRZ is a mortgage REIT that pays out the bulk of its cash flow in dividends. It currently is paying out about 87% of its earnings and there is a dividend yield around 11%. Dividends have been increasing for the past four years.
The opportunities for pure investments that benefit from rising rates are limited due to the flat yield curve, but special situations such as NRZ do exist.