The Motley Fool

2 Ways to Play the Inevitable Rise in Interest Rates

With the Bank of Canada recently announcing no change in the historically low 0.75% overnight interest rate—largely due to the continued economic impact of low oil prices—this may seem like a strange time to discuss rising interest rates.

The reality is that no time is better. While it is possible that interest rates could see one further leg down (Morgan Stanley estimates a 33% chance of this occurring in 2015), the most likely scenario seems to be that interest rates will hold throughout 2015, with a rate increase likely occurring in early 2016.

The rationale? The Bank of Canada estimates that the previous decline in interest rates should negate some effects of lower oil prices, and in conjunction with a lower Canadian dollar and improving U.S. demand, should result in improved exports, investments, and consumption. As a result, the Bank of Canada is predicting 2% inflation and average GDP growth of 2.5% over the next three quarters.

Even if the economy underperforms these targets, an eventual return to normal interest rate conditions is inevitable, and investors can prepare by having exposure to Manulife Financial Corp. (TSX:MFC)(NYSE:MFC), and Toronto-Dominion Bank (TSX:TD)(NYSE:TD).

Why Manulife is a smart rising-interest-rate play

Insurers are one of the sectors that benefit handsomely from a higher interest rate environment, and Manulife is one of the Canadian insurance companies with the largest earnings and capital sensitivity to an increase in interest rates.

Insurance company earnings benefit from rising rates due to the fact that their reserves (where they invest premiums that are set aside to pay future claims) are often largely invested in fixed-income, interest-sensitive instruments like bonds. As rates rise, insurance companies earn more investment income from these reserves, which boosts earnings and decreases premiums. Manulife estimates a 0.5% interest rate hike would boost earnings by about 3%.

At the same time, insurance companies see increases to their capital when interest rates rise, and Manulife’s MCCSR (a measure of how much capital a firm has relative to liabilities) would increase by 5% for a 0.5% hike in rates.

Toronto-Dominion Bank is poised to benefit as well

Similar to insurance companies, banks also benefit from interest rate increases. Bank’s largely make money through their net interest margin, which refers to the spread between the interest earned on their assets and interest paid on their liabilities, which includes interest to depositors.

As interest rates rise, banks often need to re-price their assets and liabilities to conform to rising interest rates. This means that as loans gradually come due, they will be re-priced at a higher interest rate, earning a greater net interest margin over time as loans come due. This is due to the fact that a bank’s assets are more sensitive to interest rates than a bank’s liabilities, and many liabilities (such as chequing accounts) are zero-cost, earning a large spread immediately.

TD Bank has the largest percentage of demand and notice deposits (low-cost deposits) to total loans among its peers, meaning they benefit from an increase in rates. In addition, TD’s large American exposure (through its 1,300 retail branches and TD Ameritrade) positions it to benefit from a potential rise in U.S. interest rates this year, which is looking far more probable than a Canadian interest rate hike.

TD Ameritrade is also set to benefit almost immediately from an increase in rates. E-brokers like TD Ameritrade typically benefit from rising rates as clients make more trades due to presumably stronger economic activity, but also from stronger net interest margins, as e-brokers typically invest clients’ deposits just as banks do.

TD Ameritrade is highly sensitive to interest rate increases and estimates that a 1% increase in U.S. interest rates would add $0.36 to earnings per share, representing a 25% to addition to 2014’s earnings per share.

TD is one way to play the rise in interest rates, but other banks will as well. If you own bank shares, you won't want to miss our latest report!

Canadian banks are considered must-have investments. After all, they're very stable, well-capitalized, and face limited competition. That said, there are concerns for the banks and their investors. In this FREE report, we cover everything you need to know about Canada's big five—whether you're already an investor or are considering buying shares. Simply click here to receive your special FREE report, “What Every Bank Shareholder MUST Know."

Fool contributor Adam Mancini has no position in any stocks mentioned.

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