10 Financial Stock Picks for Rising Rates From UBS

NEW YORK ( TheStreet) -- With long-term U.S. Treasury yields on the rise, investors need to consider which portions of their portfolios will fare best under long-term and short-term scenarios.

Long-term U.S. Treasury securities were trading at a yield of 1.81% Tuesday morning, with yields as high as 1.91% on Jan. 3, rising from a range of 1.60% only a month earlier. During this painful economic cycle, U.S. Treasury yields briefly went as low as 1.38% in July.

UBS analyst Brian Meredith late on Monday said that his firm's "economics team expects increases in U.S. interest rates (10-year Treasury yields up 60bp in 2013 and again in 2014) and a steepening yield curve." The steepening yield curve would, of course, benefit lenders and would fit in with the Federal Reserve's recent actions.

The central bank in December announced that it would continue its purchases of mortgage-backed securities at a pace of $40 billion a month, and would also continue buying back long-term Treasury securities, "initially at a pace of $45 billion per month," however, the Fed stopped its simultaneous monthly sales of $45 billion in short-term Treasuries, which is likely to have the effect of increasing demand and holding short-term rates down.

UBS expects "increases in longer-term U.S. interest rates and a steepening yield curve," forecasting for "year-end 10-year Treasury note yields to rise from 1.8% in 2012 to 2.4% in 2013 and 3.0% in 2014 (as shorter-term Treasury yields remain little changed during the next few years)."

"Historically, the stocks in most of the industries within the financial services sector have demonstrated moderately strong, positive correlations with U.S. Treasury yields," Meredith Said. According to UBS's data, with some information provided by FactSet, the S&P 500 ( SPX.X) rose 14% from Oct. 19, 2010 through Feb. 8, 2011, when the yield on 10-year Treasury paper rose by 125 basis points and two-year Treasuries saw their yield climb by 49 basis points. Meanwhile, stocks of "ebrokers" -- the group that includes Charles Schwab ( SCHW) and TD Ameritrade ( AMTD) -- rose 27% as a group, large-cap commercial banks were up 20%, and several other groups saw double-digit stock price increases, including life insurers, trust banks, and universal banks and brokers, which is the group that includes Bank of America ( BAC), JPMorgan Chase ( JPM), Citigroup ( C) and Morgan Stanley ( MS).

What If Short-Term Rates Rise?


The "ebrokers are most levered to higher short-term rates as much of the client cash is invested relatively short term," Meredith said. "With average durations of ~2 years, longer-term rates will also have an impact as the portfolio rolls over. We estimate that a 200bps rise in the Fed funds rate would increase SCHW's earnings by about 115%. The impact for AMTD is somewhat lower at 45%."

Of course, any company running money market funds is likely to feast on any scenario that includes a significant rise in short-term rates, because most are being forced to subsidize the rates being paid to investors, since the market rates are too low even to cover the customary management fees.

In a scenario of rising short-term rates, Meredith said that in addition to Schwab and Ameritrade, his "top picks" would include the following companies:
  • Bank of New York Mellon (BK). Meredith said that "BK has a highly asset sensitive balance sheet, which will drive margin and net interest income as rates," and that the company "has an added benefit of recouping waived money-market fees upon the first 25bp rise in short-term rates." UBS estimates that a rise in short term rates of 100 basis points would lead to a 10% increase in earnings per share for the company.
  • Comerica (CMA). Calling the Dallas lender "the most sensitive to interest rates" among the mid-cap banks covered by his firm, Meredith estimates that "an increase of 200bp in short-term rates would result in a 10% increase in Net Interest Income"
  • Morgan Stanley (MS). The company's plan to complete its purchase of Citigroup's stake in the Morgan Stanley Smith Barney joint venture this year will cause its deposit base to "roughly double" according to UBS, "thus increasing MS's asset sensitivity (exposure to higher short-term rates via its deposit spread)."
  • Aon PLC (AON). The company would be expected to benefit from increased fiduciary income.
  • RenaissanceRe Holdings (RNR). Meredith said that "higher interest rates would give a relatively fast boost to net investment income," because of the company's "very short asset duration."

While the firm estimates a major benefit to earnings for the above companies in a scenario of rising short-term rates, however, UBS's "base case" is for short-term rates to pretty much stay where they are, as long-term rates rise through 2014.

Top Picks for Rising Long-term Rates


UBS sees life insurers as the strongest group in its "base case" scenario for rising long-term rates, with short-term rates staying at or near their historically low levels through 2014.

Meredith said that "higher long-term interest rates would provide some relief from the downward pressure in recent years on life insurers' portfolios yields and investment spreads," although the improvement in earnings would be gradual, because of the relatively long durations of the companies' investment portfolios. "Therefore, we see sentiment improvement as the main driver of life insurance stock outperformance in a scenario of higher long-term interest rates."

Here are the three insurers that Meredith said would fare the best in UBS's rising long-term rate scenario:
  • Lincoln National (LNC) and Unum Group (UNM). Meredith said that since rising long-term rates would benefit all life insurers, "we prefer companies that can generate strong, above-peer book value per share (BVPS) growth, supported by stable operating and net ROEs and aggressive capital management," which would "support the stock prices of LNC and UNM even if interest rates fall and multiples contract."
  • The Hartford Financial Services Group (HIG). Meredith said that "higher interest rates likely wouldaccelerate the run-off of the company's annuities business (thus improving the perceived risk profile)."

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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