The average yield for Government of Canada bonds is between ~1.2% and ~2.2%, respectively, depending on the length until maturity. The further off the maturity date, the higher the interest rate.
Some investors fear that if interest rates continue to rise, investors will lower their stock exposure, which will lead to a pullback in the stock market.
Furthermore, higher interest rates lead to increased borrowing costs, which slow down the growth of companies.
That said, there are companies that benefit from higher interest rates, including Fairfax Financial Holdings Ltd. (TSX:FFH) and Manulife Financial Corp. (TSX:MFC)(NYSE:MFC).
Fairfax Financial
The stock has underperformed in the last 12 months by falling ~15% compared to the market, which has appreciated ~6%. A part of the reason was due to the hedges Fairfax Financial had. Since removing the hedges from its equity portfolio, the stock has done better and bounced ~10% from its lows.
Through its subsidiaries, Fairfax Financial primarily engages in property and casualty insurance and reinsurance and the associated investment management.
At the end of the second quarter, Fairfax Financial had ~$5 billion of cash and cash equivalents, ~$6 billion of short-term investments, ~$7.4 billion of government and corporate bonds, which generate interests and together make up nearly 72% of its investment portfolio. Higher interest rates will benefit most of these assets and allow the company to generate more income.
Under the normal course of action to manage risk, in the first half of 2017, through the sales of long-term U.S. treasury bonds (net proceeds of $152.8 million) and state and municipal bonds ($1.96 billion), Fairfax Financial’s exposure to a rising rate environment was reduced.
Manulife
Manulife shares have greatly outperformed in the last 12 months by rising 50% as the stock was severely undervalued in August 2016. Back then, the company traded below a multiple of 10.
The stock has been experiencing a reversion to the mean and now trades at a higher multiple of 12.3 at just below $26 per share. Barring a market correction, the stock will likely tread steadily higher as analysts estimate that the company will grow its earnings per share by 9.8-11.7% per year for the next three to five years.
At the end of the first quarter, Manulife had about 86% of its invested assets in fixed-income investments, such as corporate bonds, government bonds, mortgages, private placement debt, and cash. Higher interest rates will allow the company to earn a higher rate of return.
Investor takeaway
Both companies’ fixed-income investments will benefit from rising interest rates.
Between the two, Manulife is a simpler business and offers a yield of nearly 3.2%, which is higher than the 2.1% yield offered by Fairfax Financial. Additionally, Manulife has hiked its dividend for the fourth consecutive year on this year’s increase and is priced at a better value.
That said, with the equity hedges, which were dragging down Fairfax Financial’s stock, now gone, the shares should have some upside potential in the next 12 months, barring the occurrence of a black swan scenario.
