Rising interest rates are bad for stocks. This is a piece of conventional market wisdom that holds true most of the time. High interest rates take a bite out of future value, and they make borrowing more expensive. As a result, stocks typically go down when interest rates go up. However, there is one sector that can sometimes benefit from rising interest rates: financials.
The effect isn’t guaranteed, but provided that rising interest rates do not cause a recession, then banks and brokerages usually make money off of higher rates. Last month, the big U.S. banks reported earnings, and almost all of them reported higher net interest income. The reason they reported higher interest income is because they charged higher interest rates. If the economy had collapsed in the third quarter, their higher rates wouldn’t have mattered, because there’d be fewer loans in total and more defaults. But the U.S. economy actually grew at 2.6% in the second quarter, so the banks made a lot of money off of rate hikes.
In this article I will explore three stocks — two Canadian and one American — that could benefit from this effect.
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First National
First National Financial (TSX: FN) is a Canadian lending company that helps people get mortgages. It isn’t a bank stock, as it doesn’t do savings and non-mortgage loans, but it benefits off of rising interest rates much like banks do.
The company partners with mortgage brokers to find people who are looking for mortgages. Sometimes home hunters are unhappy with the rates their banks offer them and go to mortgage brokers to get better rates. First National finds customers this way; it makes money by collecting interest on mortgages it issues to them.
In its most recent quarter, First National’s revenue increased by 10%. That was partially due to the higher interest rates observed in the period. If the Bank of Canada keeps raising rates, then FN could keep benefitting from the hikes — provided that the rate hikes don’t drive the country into a recession.
TD Bank
Toronto-Dominion Bank (TSX: TD) is Canada’s second-biggest bank by market cap. It issues loans in Canada and in the United States. Its U.S. business really thrived in the most recent quarter.
In the third quarter, TD’s U.S. segment delivered 11% growth in profit, driven by a blowout quarter from Charles Schwab, a brokerage that TD owns 10% of. Thanks to Schwab’s beat, TD managed to deliver 6.6% growth in adjusted earnings in the quarter. “Adjusted earnings” means earnings with some adjustments made to conventional accounting rules. The reported earnings were a little weaker, but we’re seeing enough strength from U.S. banks to believe that TD’s upcoming quarterly release will be a strong one.
First Horizon
First Horizon National (NYSE: FHN) is a U.S. bank that is in the process of being bought out by TD Bank. If you buy it today, and if TD closes the deal, you’ll realize a small 2.66% arbitrage profit. That might not sound like a whole lot, but TD is supposed to close the FHN deal this month, so this entire trade could play out over just a few weeks.
I’ve been aware of the TD/FHN deal for a while now, and I’ve never recommended buying FHN — the reason being that there is a real risk the deal doesn’t go through. However, FHN’s earnings last quarter were so good that the bank is now a decent buy just based on fundamentals. In its most recent quarter, FHN reported a 55% increase in net revenue and a 29% increase in earnings. If it can keep up these results, then the company will not be as overvalued, as it looked when TD announced the deal. So, it could be worth holding whether TD closes or not.
