Which Stocks to Buy if Interest Rates go up

Equity investors can be guilty of ignoring the repercussions of bond-market movements, but Foolish investors might not want to be so complacent. Year to date, 10-year Treasury rates have gone up significantly, and even though it's a less than 1% move, it represents a near 50% increase in the rate. The economic impact has already been felt in some ways, and it's time to look at which stocks could benefit if rates rise further.

Rates on the move
Here's how the benchmark 10-year U.S. Treasury yield has moved this year:

Source: Yahoo! Finance.

Clearly, rates have moved up recently. In addition, its noticeable how low they still are when compared to previous years. So, which stocks can outperform if they move up?

Rates up + economy up = time to buy financials
Financials will benefit in this scenario because an improving economy will bring increased loan demand, while rising rates should increase net interest margins for the financials.

For example, although Wells Fargo  recently reported record quarterly net income, its net interest margin has been declining for more than a year now.

Source: Company presentations.

An improving housing market, however, will aid its mortgage loan origination business, and increased interest rates should help it issue loans and mortgages at higher rates than it has in the last year or so.

A similar dynamic applies to a lender like Capital One Financial . Wells Fargo and Capital One have been challenged over the last few years because of weak loan demand. In addition, it has been trying to replace loans issued at previously higher rates. The result is that income has come under pressure. However, there are some positive signs. Capital One is known for being a conservative lender, so it's a good sign when its management says this on a conference call:

New originations are growing, and we're seeing more opportunity to increase credit lines for existing customers, which should improve the trajectory of both the loan growth and purchase volume growth over time.

Capital One expects its domestic card-loan growth to turn positive "sometime around the second half of next year."

Rival lender Discover Financial Services   is a somewhat more aggressive lender, and it managed to grow its credit card loans by 4% in its third quarter even while its credit card charge-off rate hit a record low of 2%.

Moreover, its management described the market as being a "very benign credit environment. We don't see any situation where there is any type of a meaningful deterioration in credit in the near-term horizon at all."

Although not a financial, Automatic Data Processing , or ADP, holds large amounts of its payroll clients' funds on its books, from which it earns interest income.

ADP is interesting because its employer services and professional employer organization, or PEO, services are obviously geared to the economy. In addition, the company is achieving margin expansion as its revenue grows. In fact, in its third quarter, employer services (69% of revenue) grew earnings by 15%, and PEO (18% of revenue) did so by 12%. The main reason its total pre-tax earnings only grew around 7% was because lower interest rates took its interest income down by $17.6 million, to $89.2 million. Given higher rates and an improving economy, ADP has plenty of upside.

In a similar vein, payroll specialist Paychex  (NASDAQ: PAYX  )  also holds significant amounts of customers cash on its books. You can see how the cycle works in the following graph.

Source: Company presentations.

As the economy improves, more small business want use Paychex's payroll services. Consequently, the amount of funds held goes up. Meanwhile, interest rates tend to go up, so the amount earned from customer funds goes up. In fact, it went up to around 8% of total revenue in 2007. If the same thing happens over the next few years, Paychex could see a revenue boost from this effect.

The bottom line
Foolish investors need not fear rising rates because they're usually a sign of a stronger economy. With a relatively benign inflation environment, the stocks discussed above have upside. The financial media often frets about higher rates, but Foolish investors can prepare for them and invest accordingly.