Dave Mazza, Head of Research for SPDR exchange-traded funds at State Street Global Advisors (SSGA), offers insight into the likely implications of the first interest rate hike in the US for nine years. His note explains the uncertainty surrounding the market’s reaction, the possible path for interest rate movements next year, and how investors may use ETFs to benefit from the move off zero.

Dave Mazza, Head of Research for SPDR exchange-traded funds at State Street Global Advisors.

With the decision to begin normalising interest rates, the Federal Reserve (Fed) has officially chartered a course for US monetary policy that fully separates itself from the rest of the world. The act shows faith in the continual recovery of the US economy and is the beginning of the Fed’s stated plan to slowly and incrementally raise rates over a number of years.

Fed Chair Janet Yellen acknowledged that sudden tightening could result in financial market turmoil and possibly an untimely recession. Upon this reasoning, SSGA predict four quarter-point rate hikes during 2016, supported by labour market recovery and gradual increases in inflation. The note suggests adopting a long-term standpoint when investors build their fixed income ETF portfolio, positioning themselves to benefit from the measured recovery of the economy, but also highlights methods to insulate exposure from any short-term market uncertainty.

With a focus on long-term core fixed income ETF holdings, investors could consider sector-diversified, traditional and non-traditional exposures with offsetting risks to form better risk-adjusted returns in a wide variety of market conditions. A focus on high quality investment grade securities is a sensible choice for core exposure while high-yield ETFs could make up a portion of the satellite holdings.

In the short-term, to better brace against any immediate volatility in the markets as market participants attempt to gauge the impact of the Fed’s move on the yield curve and the health of corporate balance sheets, investors may be relieved to know there are more options available rather than indiscriminately selling long-dated exposures or relying on a broad fixed income benchmark like the Barclays US Aggregate Bond Index.

One potential solution is to incorporate actively managed ETFs within the core fixed income exposure. A focus on diversification and strict risk management constraints are still essential; however, an experienced management team may be most knowledgeable in navigating the uncertain market movements ahead. Divesting the more complex decisions of short-term tactical allocation to those specialising in the field may put investors at ease. For those interested in this alternative, the SPDR DoubleLine Total Return Tactical ETF (TOTL) may be a viable option.

Short-term investment-grade floating-rate notes and senior secured loans may present a second alternative for investors. The focus here is on a profile of low portfolio duration and floating coupons to offset potential losses in principal from rising rates. The SPDR Blackstone/GSO Senior Loan ETF (SRLN) and the SPDR Barclays Investment Grade Floating Rate ETF (FLRN) would suit this function. A final offered solution would be the inclusion of the SPDR Barclays Convertible Securities ETF (CWB) which may enhance portfolio returns through income opportunities as well as provide diversification benefits.

Turning to equity, sectors which often provide superior returns at the start of a tightening cycle include consumer discretionary and financials. SSGA provide a suite of sector-specific equity ETFs including the Consumer Discretionary Select Sector SPDR Fund (XLY) and the Financials Select Sector SPDR Fund (XLF).

Within industries, SSGA has tipped the superior performance of the homebuilders trade. With unemployment low at 5% and the economy continuing to improve, the stage is set for a boost in the housing market. The SPDR S&P Homebuilders ETF (XHB), by including firms operating in the refurbishment and home improvement space, offers a more diversified exposure than a narrow investment in housing construction.

Regional banks may also outperform as rising rates allow banks to boost profits by increasing their margins in their loans. With an improving economy, demand for loans to finance business expansion is generally not affected by rising interest rate terms. Regional banks have historically been significant commercial lenders during this stage of the cycle and investors may wish to exploit this trend through the SPDR S&P Regional Banking ETF (KRE).