Finance ETFs Ease Rate Pain

Banks and brokerage stocks have been huge winners over the last couple years, but with rates threatening to move higher, there are some definite advantages in switching out of individual financial names and into diverse financial sector exchange-traded funds.

Banks and brokerage stocks have risen since 2003, primarily because long-term interest rates have remained stubbornly stable. But Wall Street has grown anxious in the last month or so at the thought that the honeymoon is coming to an end. Rising rates hurt financial stocks, because they eat into the profit margins of institutions whose businesses revolve around the debt markets.

When a higher-than-expected core producer price index was announced in mid-February, for example, the fear of inflation caused the yield on the benchmark 10-year Treasury bond to jump 8 basis points to 4.26%. The rise in yields promptly led to heavy selling in financial shares. Soon after, a Bank of Korea announcement stating that it intends to diversify its currency holdings caused 10-year rates to rise 3 more basis points and sent financial stocks even lower.

Particularly at risk in this environment are brokerages with big bond-trading and debt-underwriting operations such as Bear Stearns (BSC Quote) and Lehman Brothers (LEH Quote), which would feel the pinch if climbing rates were to dissuade new issuers from coming to market. Financial services firms tied to the mortgage market, such as Fannie Mae(FNM Quote) and Freddie Mac (FRE Quote), would also be susceptible if higher borrowing costs brought down the soaring housing market.

"Higher rates may curb new-home sales and refinancings, which have been big moneymakers for the banks and financial services companies when rates were dropping," says Sam Stovall, market strategist at Standard & Poor's.

Investors have good reason to anticipate a step up in borrowing costs, considering that the Fed has lifted the overnight lending rate six times since last June. And most market analysts predict that it isn't done yet, thus making the situation even more slippery for the financial sector.