Stocks to buy when interest rates rise

Rising interest rates are usually considered bad news for stock investors. Throughout the market, stock prices tend to fall as interest rates rise.

However, not all stocks respond equally to rising interest rates. Some types of stocks actually get a boost from higher interest rates, while others benefit from the macroeconomic conditions that prompted the Federal Reserve to raise interest rates in the first place. At the same time, some types of stocks fall farther than the market as a whole.

We'll explore the types of stocks investors can buy when interest rates rise.

How do rising interest rates affect stocks?

Throughout the stock market, rising interest rates typically cause stock prices to fall. Companies face rising borrowing costs, forcing them to reduce growth. This in turn reduces expectations for their future earnings.

At the same time, companies have to spend more money to service any existing debt with variable interest rates. As companies pay more of their revenue to service debt, their net profits decline.

Higher rates also increase the value of newly issued bonds and Treasury bonds. This causes money to flow from the stock market into bonds, causing stock prices to fall further.

The result of these conditions is that most stock prices fall when interest rates rise.

Best stocks to buy when interest rates rise

It is worth noting that there are some types of companies that benefit from rising interest rates. It may still face higher borrowing and debt costs, but there are other factors driving up its share prices.

Bank stocks

Bank stocks are among the stocks most likely to gain value when interest rates rise.

The first way banks benefit is by increasing interest payments on outstanding loans. Higher rates translate directly into more profits on a variable rate loan, so banks see higher profits when rates rise. The more variable-rate debt a bank has, the more profitable it can be.

Another way banks benefit from higher interest rates is that they make more money on deposits. When interest rates are low, banks usually earn a small spread between the interest rates they pay to depositors and the rates they earn on Treasury bills. This is because they want to compete with other banks and credit unions to attract deposits.

However, when interest rates rise, banks have more scope to increase this spread. They may keep interest rates for depositors as they are and hope that depositors do not leave. Alternatively, they may raise deposit rates by less than the change in Treasury bond prices.

Insurance stocks

Insurance companies also benefit from higher interest rates because they hold vast amounts of Treasuries and other low-risk bonds. These holdings allow insurance companies to make money on customers' insurance premiums while ensuring they have the money to cover claims.

Some Treasuries and bonds held by insurance companies have variable interest rates that increase when interest rate hikes are announced. Even if insurance companies see no changes in their yields from the bonds they already own, any new bonds they buy will offer higher interest rates.

Manufacturing stocks

Higher interest rates are often a response by the Fed to a hot economy. Raising interest rates aims to calm spending so that the economy does not overheat and collapse.

There are many types of stocks that can benefit from a strong economy even if there are headwinds from higher interest rates. In particular, manufacturing stocks could see increased demand for things like home appliances and cars if consumers have extra money and positive expectations.

However, investors should note that manufacturing stocks do not perform well as interest rates rise. Some manufacturers may see their revenue decline as commercial customers scale back growth plans. Investors should primarily consider manufacturers that produce large consumer goods.

Consumer discretionary stocks

Another class of stocks that can benefit from consumers' positive outlook on the economy are consumer discretionary stocks. People may take more vacations, which will benefit hotel stocks. They may eat out more, which will benefit restaurant stocks. They may also bring in a long-awaited home remodel, benefiting appliance stocks.

However, investors should be wary of consumer discretionary stocks that have large amounts of debt, as we'll discuss more below. For example, while airlines may see revenues increase as consumer travel rises, airlines typically also carry high debt loads. Therefore, they could end up taking a hit due to rising interest rates.

Stocks to avoid when interest rates rise

There are also some types of stocks that are likely to be more affected by rising interest rates than the overall market.

Companies with high debt

Companies with high debt are more likely to see their stock prices decline when interest rates rise. These companies will have to pay more interest on any existing loans or bonds with variable interest rates. This means that they make less profit and produce less profits. In extreme cases, companies with high debt loads may be forced to cut their dividends.

Companies with high debt can be found in all industries. However, they are particularly prevalent in the construction and aviation industries, so investors may want to avoid these stocks when interest rates rise.

When evaluating stocks, keep in mind that not all debt becomes more expensive when interest rates rise. Only debt with variable interest rates will require higher payments immediately or in the near future.

Growth stocks

Growth stocks are not directly harmed by rising interest rates in the same way that companies with high debt are. However, growth stocks can see their prices decline when rates rise.

The reason for this is that the high prices of growth stocks depend on future growth. As borrowing becomes more expensive, these companies become less likely to meet investors' growth expectations. Lower expectations for future earnings lead to lower valuations, causing investors to sell and prices to fall.

Construction and real estate stocks

The housing, commercial real estate, and construction markets rely heavily on debt. When borrowing costs rise, people are less likely to buy homes and businesses are less likely to demand new buildings. This leads to a contraction in demand for both construction and real estate.

Investors should especially stay away from stocks allocated to homebuilders, as new home construction typically declines when interest rates rise. REITs that generate most of their income from rentals may weather higher interest rates without issuance, but REITs that use debt to purchase properties will likely see their prices decline.

Investment strategies when interest rates rise

Besides investing in industries that benefit from rising interest rates, there are two main things investors should consider when interest rates rise.

Be conservative

In general, market volatility rises and stock performance declines when interest rates rise. There may be individual companies that see their stocks rise, but overall investors should take a conservative approach to the market. Periods of rising interest rates can be a good time to invest in low-risk bonds or to accumulate cash to invest in stocks when rates start to fall.

Avoid investing during Fed meetings

There are eight regularly scheduled meetings of the Federal Reserve each year, and announcements about interest rate changes usually follow shortly after these meetings. The market is often tense in the days before and after a Fed meeting when the central bank is in the midst of raising interest rates.

This volatility can make investing more difficult. Stocks may rise after an announcement that interest rate increases will be paused, only for the mood to turn sour a day or two later and cause prices to fall again.

Investors can avoid the worst of this volatility simply by avoiding investing during Fed meetings. Investors who want to buy stocks during these meetings must practice dollar-cost averaging.

Bottom line: Buy stocks when interest rates rise

Higher interest rates cause most stock prices to fall. However, there are stocks in some industries, including banking and insurance, that directly benefit from higher interest rates. Additionally, stocks in manufacturing and consumer discretionary industries can benefit from a hot economy, which is often the root cause of price increases. Investors should be careful about investing in companies with high debt, growth stocks, or stocks in the construction and real estate industries.