Federal Reserve Chairman Ben Bernanke speaks during a press conference on June 19, 2013 at the Federal Reserve Board Building in Washington, DC. (Image credit: AFP/Getty Images via @daylife)

The specter of rising interest rates has many investors—particularly retirees with large bond holdings—very worried. But we think we’ve found a potential way to play the interest-rate shift: by investing in certain types of financial companies that hold large sums of customer cash, and are required to invest that money in short-term government bonds. Because of the interest they can earn from those holdings, higher rates could mean higher earnings for these firms.

We’ve assembled a high-quality list of such companies in our “Rising Interest Rates ” motif, which is the featured motif this month at our firm, Motif Investing. This portfolio of stocks include online-brokerage firms, which earn interest income on un-invested cash in customer accounts; payroll processors, which hold large cash balances for clients before distributing the money as payroll; and custodian banks, which hold securities on behalf of other banks and earn an interest “spread” on them. The companies in this motif derived on average about 23% (down from 35% five years ago) of the revenue from such interest related activities. To enhance exposure to rising rates, our investing team weighted the stocks in this motif by current assets, which are most sensitive to changes in rates.

There is historical precedent for these types of firms to benefit when rates rise. From 2003-2004, the Federal Reserve increased its overnight Fed Funds rate from 1.25% to 2.25%. During this same period, the major online brokers—TD Ameritrade, E-Trade, Interactive Brokers, and Charles Schwab—saw their interest income jump by 38%, which led to a 10.6% increase in operating margin. In 2012, Charles Schwab, the publically traded broker with the largest asset base, said it expects a 19.2% increase in net interest revenue for every 1% increase in benchmark interest rates.

It’s unclear when, or by how much, interest rates will rise this year and next. But the scenario seems likely.

Since the 2008 financial crisis, the Federal Reserve has taken unprecedented steps to lower rates to encourage borrowing and stimulate economic growth. This activity has pushed the Fed Funds target rate to near zero—meaning rates basically have nowhere to go but up. In addition, the Fed has employed a policy called “Quantitative Easing” to target interest rates further out on the yield curve.

The policy has been in large part judged a success, if only because it helped spare the U.S. economy from a complete meltdown. Recent comments by Fed Chairman Bernanke suggest that the central bank expects this ‘highly accommodative policy’ to continue for the foreseeable future as economic signals remain mixed. That said, talks around the central bank scaling back its bond purchases in the coming months if the economy improved, have led to significant volatility in the markets. The recent sell-off in bonds indicates the market’s uneasiness over a tapering of the Fed’s bond-buying program. Since the beginning of May, the yield on the benchmark 10-year Treasury note has risen to 2.60% from 1.6%, the biggest single move in interest rates since 1962.

The recent surge in bond yields doesn’t necessarily mean interest rates will march up immediately. Interest rates have experienced temporary spikes a number of times in recent decades. But the surge does remind us that investors need to prepare their portfolios for a future in which interest rates do not remain at the historic low levels of the last few years. While rising interest rates will adversely impact the nascent recovery as it increases the cost of borrowing for companies and the government, and squeezes mortgage refinancing, the group of firms represented in the “Rising Interest Rates ” motif may help investors weather this rising-rates cycle.

Disclosure:

Author has been holding a position in the “Rising Interest Rate” Motif since January 22, 2013.