Financial and economic

How to Invest During a Period of Rising Interest Rates

Summary

  • To deal with rising interest rates, I propose a portfolio that consists of 50% stocks, 10% emerging market bonds*, 10% floaters and 30% in various short term bonds, of which mostly corporates with higher yields
  • Avoid long duration bonds, and take selective exposure to higher yielding short term and floating rate instruments to maintain fixed income exposure, yet adding a yield cushion to offset duration negative returns. I would also advise to steer away from gold, commodities, REITs and inflation linked bonds (unless, of course, the rising rates are entirely driven by inflation and central banks are chasing after the facts, but that currently does not seem a likely scenario)
  • Stocks and high yield corporate bonds will be expected to perform well in the initial rate hiking cycle, though care needs to be taken once the business cycle starts moving against them and interest rates potentially reverse, at which point you will want to shift from short-term bonds to longer maturities, and reduce your risk asset exposure. The portfolio at hand will work well until that moment

* for anyone questioning this based on conventional wisdom that EM will sell off during periods of rising rates (e.g. taper tantrum 2013), consider that between July 2016 and February 2018 US 10 year interest rates increased by nearly 1.6% (1.36% to 2.95%). In the same period the JPMorgan GBI-EM Global Diversified returned +11.9%. Naturally there will be short term volatility but I am proposing a portfolio that will see you through this event for the medium term.

Background

Between 2009 and 2015 the US Federal Funds Target Rate seemed to be perennially stuck between 0% and 0.25%. Monetary conditions have been gradually tightening since then, and as of writing, US rates have reached 1.5%, though imminently to be raised yet again. Even some European interest rates have been slowly zigzagging their way up as economic prospects improved, and both monetary and structural trends should be expected to speed things up sooner or later as well.

Back in the US, the market currently expects anywhere between two and four more (25bps each) hikes this year, as well as a further two in 2019, by when short term rates thus could be as high as 3%. In the meantime long-term rates have been following their own path, with the 10 year yield largely stuck between 1.5% and 3.0% (and the occasional spike upwards like the 2013 taper tantrum of the Q4 2016 “Trump trade”). It is currently testing the upper boundary of that range.

Low interest rates made for ample liquidity and affordable borrowing, aiding economic growth and the stock market (which is still in the midst of a now nearly decade old bull market as of writing, though facing some headwinds recently) as equities were more attractive than most other investments. What will happen to the stock market if we take that catalyst away? And how will the various types of bonds respond?

Extent of hikes will depend on the US economy

Much of the extent and speed of future hikes will depend on how well the economy does: in particular job market and inflation dynamics and how fiscal stimulus and talk about tariffs on Chinese technology and global steel affects both.

It will also depend on how the Great Unwinding will play out: we are at the start of the unwinding of Quantitative Easing and Fed balance sheet reduction, which will drain liquidity from the system and very likely put downwards pressure on US treasuries and upwards pressure on US interest rates. In fact, some of the current conditions are reminiscent of those that could cause stagflation.

Then there is the question of international capital flows (does the PBOC keep buying treasuries, at what time does a 3%+ yield for AAA become irresistible for sovereign wealth funds, central banks and the like) and the risk environment (risk off markets tend to increase appetite for treasuries).

So what’s next simply isn’t very clear cut and only partly controlled by the Federal Reserve. Most agree though that bar some unexpected economic headwinds or a geopolitical shock event, short-term rates will keep trending up for near term maturities, but what happens on the longer end of the curve is less certain.

However, what is certain is that should rates indeed rise further, that will practically affect every other type of financial asset. In some cases directly, in others indirectly. Here we outline how to position your portfolio for such a rising rates environment. In fact, the below portfolio should be largely immune to shocks in interest rates, and be expected to perform well in all monetary conditions.

But structural issues could also push yields higher

In the short term economic conditions may be expected to push rates higher, but what about structural issues? An ageing population could mean a reduction in savings, which some say will push yields higher (in a reversal of the trend lower that it has caused over the last decades) while others point at the fact that this trend reduces the labor force growth, bringing down economic growth and interest rates in the longer term.

Another school of thought says that technology is responsible for low inflation which could keep interest rates down for longer. Economists are divided, it appears. Perhaps structural issues are best ignored when making changes that should help your portfolio get through the next year or so.

Business cycles, shape of the yield curve and key rate duration

As yields press higher, there has been a bit of noise lately about the shape of the yield curve. The Fed is able to directly manipulate the short end of the curve, but the longer end of the curve is driven by forces of supply and demand driven by economic expectations, and that longer end has been staying in place. That is what would be expected to happen when market participants foresee a recession coming up.

One statistic to be aware of in relation to this is Key Rate Duration. This is a metric that measures sensitivity of your portfolio to every point of the yield curve (2 years, 5 years, 10 years, 30 years, etc.) and can tell you how much a portfolio stands to gain or lose.

By rule-of-thumb math, a bond with a duration of 20 years may lose as much from a 0.05% change in interest rates, as a bond with a duration of 1 year from a 1.0% shift. That may be important to keep in mind once the economy starts turning, in order to properly weigh the trade off between short term and long term bonds in your portfolio.

Assets to avoid in periods of rising interest rates

  • US Treasuries: Interest rates go up, treasuries go down. Basically yes, but it’s not quite that easy: that Treasury Bills (the shortest term notes) will decline is a given, but how longer maturities respond is less certain and will depend on longer term economic expectations: are we getting stagflation (short term bonds get hit, longer term bonds relatively less so) or are we getting reflation (longer term bonds are especially hard hit)?
  • International government bonds and currencies: There is some degree of correlation between interest rates globally. Ceteris paribus, rising US rates will cause money to flow into the US from the rest of the world, weakening other currencies and requiring central banks to respond in kind. In the current situation where monetary policy in Japan and the Eurozone is still very loose, we would expect dollar strength and for global government bonds to underperform. Emerging market bonds may offer some reprieve through their higher yields (see below).
  • Real Estate Investment Trusts: This will largely depend on the pace of rate hikes. If they come fast and furious, dividend payouts will likely to be reduced as the cost of debt financing increases, leading to declines in REIT prices (partly offset by their high yields).
  • Inflation Linked Bonds: Bonds where the principal is indexed for inflation. As rising rates will tend to go along with rising inflation, these could in theory be the perfect hedge. But their returns above inflation may still be meagre, and if rates go up without rising inflation (as may be the case with the Fed balance sheet unwinding), you would still wind up with losses. Potentially large ones if the (nominal) duration is significantly long.
  • Commodities: In general, rising interest rates would apply downward pressure on precious metals like gold as their relative attractiveness declines. Meanwhile, oil and energy commodities could sell off as the dollar strengthens (capital flows in due to the relatively higher yields), which makes purchases by foreigners more expensive.

So what should you invest in?

  • Short Term Bonds: The duration (interest rate sensitivity) of short term bonds is lower than long term bonds. If you buy a 6 month note at a 2% yield today and rates move to 3%, you will at most miss out on several months of the higher yields. Price changes won’t be an issue as bonds mature at par. For bonds with longer maturity, the general rule of thumb that each additional year of duration leads to an additional -1% loss for every 100bps increase in rates should be kept in mind.
  • Corporate bonds: Credit bonds offer a higher yield above treasuries which cushions the blow in cases of rising rates. You will want to keep the maturities short (say 1-3 years) as their interest rate risk minus the credit spread will still be the same as treasuries. Also, high yield (junk) bonds will tend to be less affected by rising rates than investment grade bonds, but obviously come with higher risk. As AllianceBernstein points out however, credits may do well at the start of a rate hiking cycle, but may be less attractive towards the tail end of it.
  • Floating rate notes and senior bank loans: (Investment grade) Floating rate notes are usually corporate bonds that typically pay a spread above a reference rate, e.g. LIBOR+100bps. That rate is reset on a regular basis, meaning that if rates rise your coupon receipts keep getting adjusted and you are protected. The downside is of course that if rates decline from here, your yields are going right down the drain with them. Bank loans can be similarly attractive but are less liquid, have lower credit quality and may be callable, so I’d avoid them.
  • Stocks: When rates go up, dividends become relatively less attractive than bond yields which should normally put downward pressure on stocks. Moreover, rising rates will at some point cut into corporate profits which would immediately have a negative impact on companies’ balance sheets. The point at which this starts to happen is hard to discern, but many economists reckon the long term average should be 3% to 3.5%. On the other hand, in the initial stages rising rates also signals confidence in the economy, which should boost stocks and especially cyclical ones. As with REITs, the impact on stocks is likely to be correlated with the pace and extent of the rate hikes, where gradual is good, while fast and abrupt is bad. Financial stocks should do well (as the yield spread between borrowers and savers widens), and consumer discretionary, industrials, tech and materials (i.e. cyclical stocks) would generally hold their ground too.
  • Inverse bond ETFs: Inverse bond ETFs are leveraged products that deliver you the opposite returns of bond ETFs. If rates rise, you can profit at either 1x, 2x or 3x leverage. If higher rates are on their way, in principle you’d want to invest all your money in products like this, but the leverage component adds an extra risk factor and it’s very important to note that these products only deliver the returns that you would expect on single days, not over longer periods. I personally am not a big fan of these products. Take TBF (Proshares Short 20+ Year Treasury). At an estimated duration of 17, by rule-of-thumb math its return should
  • Long US dollar: the dollar would be expected to strengthen as rates go up. Never mind that as of writing the opposite is actually happening, but that appears to be driven by other forces (one of which is a strengthening euro), and over longer term rising rates = stronger US dollar remains economic orthodoxy. At the same time, much will depend on what other central banks do (the ECB and BOJ are still applying quantitative easing, should that change in the near term the picture may change). For non-US based investors, having some long dollar exposure will nevertheless be a good idea.
  • Emerging Market Bonds (Local Currency): This is kind of the opposite of the previous point, but emerging markets are in much better shape than in previous periods of rising rates and dollar strength, so their currencies are more likely to hold (some of) their ground. Moreover, yields of around 6%-7% on certain markets help to make up for any drop due to FX and rate changes, and if you pick countries with healthy current account balances you’re also more likely to end up with a more stable investment in the face of rising US interest rates.

Portfolio construction: equity, short term bonds and high yields

  • The below portfolio would be able to stomach rising rates and should be able to deliver a decent return throughout such periods. The allocation is 50% stocks/50% bonds, you can choose to scale this up or down commensurate with your own risk appetite
  • Within stocks we don’t distinguish, while bonds focus on shorter term and a good portion of higher yielding assets (high yield bonds and EMD). As rates at some point start to peak (look for the 3% to 3.5% range) you can start to shift into longer duration bond ETFs and reduce the stock allocation
  • The portfolio characteristics are shown below. The predicted volatility is 5.3% and according to our risk model, this portfolio is expected to deliver outperformance during both positive markets for equities (+6.8%), as well as in a period of strongly rising rates (+2.0%).
  • Note that this portfolio is not a directional “bet”, if rates do not rise but move the other way you would still be able to do well, there are yield generating assets included in the portfolio in both the fixed income and equity portion.
CategoryNameIDTERAlloc %
StocksVanguard Total World Stock ETFVT0.10%50.0%
Short Term BondsVanguard Short-Term Bond ETF
BSV0.10%10.0%
Corporates (ST)SPDR Portfolio Short Term Corporate Bond ETFSPSB0.07%10.0%
HY Corporates (ST)SPDR Barclays Short Term High Yield Bond ETFSJNK0.40%10.0%
Floating Rate NotesiShares Floating Rate Bond ETFFLOT0.20%10.0%
EMD Local CurrencyiShares J.P. Morgan EM Local Currency Bond ETFLEMB0.50%10.0%

Risk, diversification and allocation

  • Risk level: low
  • Diversification: medium
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 75%-100%

Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 2.10%
  • Ex-ante predicted volatility: 5.3%
  • 1 year 95% Value-at-Risk: –8.1%
  • Scenario 2008 Lehman Brothers default period: -12.4%
  • Scenario Interest rates +100bps: +2.0%
  • Scenario Equity up +10%: +6.8%
  • Scenario 2008-2009: -8.2%
  • Scenario 2010 onwards: +77.6%

 

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