Success requires consideration of changes in the shape of the yield curve.
In 1981, the yield on the 10-year U.S. Treasury bond peaked at 15.3 percent. For the next 35 years, investors enjoyed a relatively unbroken bull market in their bond portfolios. Interest rates slowly declined, and investors regularly gained annual positive returns on their investments. During this time, the income produced by these investments also slowly declined. In fact, interest on the 10-year U.S. Treasury bond fell below
1.5 percent in 2012 and again in 2016. Since this low, investors and advisors alike have watched the hawkish turn in U.S. monetary policy by our Federal Reserve result in rising rates globally. Today, many investors have asked themselves a reasonable question: How should I position my portfolio for a low but rising rate environment?
Understanding the Federal Reserve
When market participants use the term “rising rates,” they’re typically referring to increases in the benchmark policy rate set by each country’s respective central bank. In the United States, the policy rate set by the Federal Open Market Committee (FOMC) of the Federal Reserve is known as the “fed funds” target rate. The fed funds target rate is the primary tool of the Federal Reserve to fulfill their dual mandate of sustaining employment and controlling inflation.1
Interest Rates and the Yield Curve
Through the fed funds target rate, the FOMC exerts control over short-term interest rates only. Rates on longer maturities are then determined by the markets. The relationship between interest rates of varying maturities is often referred to as the term-structure of interest rates or the “yield curve.” Changes in the shape of the yield curve can be a powerful tool for investors to use to adjust their portfolios when interest rates are rising as they both signal expectations for future economic growth and have a direct impact on the performance of various asset classes.
As illustrated in “Yield Curve Movements,” p. 47, there are three different ways the yield curve might change during a period of rising rates.
1. Parallel shift. This occurs when yields of various maturities increase (close to) equal amounts, resulting in higher yields across the curve without a change in the overall shape of the curve.
2. Bear-steepening. This results when long-term yields increase at a faster rate than short-term yields. This typically occurs when economic or inflation expectations cause the market to price in higher yields on the long end of the curve, even while the FOMC is increasing the short-term fed funds rate.
3. Bear-flattening. This occurs when shorter term yields increase at a faster rate than longer term yields. This often happens when the FOMC increases rates, pushing up yields at the shorter end of the curve, while economic and inflation expectations cause long-term rates to remain static.
Each of these yield curve movements presents different considerations for investors and suggests different approaches to re-positioning portfolios.
Rethinking Asset Allocation
Since the 1980’s peak in interest rates, advisors have often approached asset allocation simply in terms of portfolio growth versus income. However, in an environment of low and rising interest rates, investors need to reconsider asset allocation and the best sources for lifestyle income needs. It’s easy to understand when interest rates were 15 percent or even 5 percent how it became commonplace for financial advisors to recommend investors own fixed income in proportion to their age. Many investors could allocate an increasing portion of their portfolio to fixed income for both assured income and portfolio diversification. A 70- or 80-year old investor could often live very comfortably off the income generated from 5 percent to 7 percent bond coupon payments from his portfolio.
In this environment, many Baby Boomers started hearing the instruction to “live off the income” of their portfolios, leaving principal untouched. Fast-forward 30 years, and this isn’t your grandparents’ bond market. It’s been many years since a portfolio of 10-year Treasury bonds produced enough income for retirees to live comfortably. In fact, it’s difficult to imagine any portfolio today of investment-grade fixed income securities that can produce sufficient lifestyle income without undue risk. In short, portfolio sources of income and capital protection have become disconnected, and investors can no longer expect to live only off the income naturally generated by their portfolios.
Many advisors have begun to encourage investors to think about their portfolios not as a combination of equities for growth and bonds for income and protection, but as a mix of three allocations—growth assets, capital protection assets and income-producing assets—that together produce a total return. Each year, a portfolio’s total return is the sum of the income it produces and the appreciation of its securities. Today, most investors who live off their portfolios must withdraw a combination of both income and appreciation. This doesn’t necessarily mean the value of their portfolios will go down; proper planning and structure with an advisor and professional portfolio manager may allow investors to withdraw total return regularly while potentially maintaining or growing the overall value of their portfolios. Using the three-bucket approach, capital protection plays its role as an anchor to windward while investors acknowledge that the growth and income sources within their portfolios all carry higher risk to support their lifestyle withdrawals. In the following sections, we’ll explore how an investor can position each of the three buckets for a rising rate environment.
Fixed Income for Capital Protection
Once investors embrace a total return approach to portfolio construction, it becomes evident that chasing higher yielding investments for the sake of income sacrifices critical capital protection in their portfolios. Instead, investors must first focus on determining the right allocation to capital protection to help mitigate the risk in other investments. Given the need for growth and other income sources in the portfolio, capital protection allocations may no longer be tightly related to an investor’s age. Depending on personal circumstances, a 70- or 80-year old investor today may have less than 50 percent of his portfolio in capital protection assets.
When determining how an investor might reposition his portfolio for protection in a rising rate environment, a starting point is to focus on fixed income duration. As rates increase, the current price of a bond will decline. Duration measures the sensitivity of a bond or bond portfolio to a change in rates. Higher duration bonds will be more sensitive to interest rate changes, and prices will change more than those of lower duration bonds. Duration accurately reflects how a portfolio’s value will change with rates. Due to this, many investors and advisors will focus exclusively on managing duration in the capital preservation allocation and invest only in bonds such as Treasury bonds, agency bonds and even certificates of deposit, leaving credit risk for the income allocation.
The duration of a fixed income portfolio is the weighted average of the duration of each of its underlying bonds. However, two portfolios with similar durations will behave very differently during a rising rate environment, depending on the distribution of bonds of varying durations within the portfolio. Depending on expected changes in the yield curve and the investor’s personal objectives, an investor and his advisor might pursue one of three common strategies for structuring fixed income portfolios for capital protection. “Impact of Yield Curve Changes,” p. 48, illustrates the differences among each of these portfolios and their performance under different yield curve movements.
1. Laddered portfolio. Laddered structures are most appropriate for investors who plan to hold bonds until maturity. As existing bonds mature, new short-term bonds are purchased at increasing rates. Many individual investors appreciate this structure for buy-and-hold portfolios as the laddered bonds will benefit from rising rates by providing both capital protection if held to maturity and increasing income over time.
2. Barbell portfolio. Barbell structures perform better when the yield curve is moving in a bear-flattener manner. Barbell strategies concentrate bonds on both ends of the maturity spectrum, creating a “barbell.” With a concentration in shorter term bonds, the portfolio regularly reinvests at higher interest rates. The concentration at longer maturities provides higher income sources to investors, with relatively less interest rate movement due to the flattening of the yield curve.
3. Bullet portfolio. Bullet structures concentrate bonds in a tight maturity band around a target duration. Investors often desire bullet portfolios when they have large cash flow needs in the future, such as a balloon mortgage payment or college costs. Though investors may require a bullet portfolio regardless of interest rate movements, bullet portfolios perform best when long rates are increasing faster than short-rates (a bear-steepener move of the yield curve).2
It’s important for an investor to work with an advisor and fixed income portfolio manager who will consider the investor’s goals, shape of the yield curve and the expected pace of interest rate increases. These professionals can analyze the potential impact on the portfolio and make adjustments accordingly.
Investments for Income
As we’ve described, during periods of rising rates, an investor and his advisor might choose to reduce the average duration of their fixed income allocation. While lower durations often protect capital, they may not deliver the income an investor seeks.
One approach to maintaining income is to add floating rate bonds to a portfolio. These bonds have varying interest rates that are tied to a benchmark, such as the Consumer Price Index, 3-month U.S. Treasury bond yields or LIBOR (London Inter-bank Overnight Rate). The price on these bonds stays relatively stable as the interest moves with changes in the benchmark. While these bonds might initially offer lower yields than higher duration bonds of a similar credit quality, the yields will reset regularly with rising rates, increasing at a faster rate than a buy-and-hold portfolio of traditional bonds. Floating rate bonds will reprice at different frequencies from monthly to quarterly and, occasionally, yearly. Often these bonds will also pay interest more frequently than a traditional bond that pays out interest twice a year. For these reasons, many investors and advisors will seek out floating rate bonds or floating rate bond funds to add to a portfolio when rates are rising.
For greater income in a portfolio, an investor and his advisor might consider using corporate or municipal bonds of lower average credit quality. This can be done by moving down in credit quality within an investment grade portfolio (AAA+ through BBB-) or allocating away from investment grade to various sources of high yield credit (BB+ or lower). Investors and their portfolio managers might choose among corporate high yield bonds or credit alternatives such as non-agency residential mortgage-backed securities or emerging market bonds. An investor might also monetize equity volatility to produce yield in the form of an option overlay strategy or structured note. All these choices might generate higher levels of income and diversify the portfolio’s overall credit exposure.
Strategies for Growth
A number of studies have demonstrated that, on average, equities tend to perform well during periods of rising rates.3 For example, “Equity Returns,” this page, demonstrates that over the past 20 years, U.S. large cap equities have delivered positive performance during the 12 months corresponding to a period of rising rates regardless of whether the yield curve adjusts in a bear-steepener or a bear-flattener manner. Both predict positive performance; however, a closer look reveals that equities deliver considerably superior performance (17 percent) during bear-steepener scenarios than during bear-flattener scenarios (14 percent). Bear-steepener changes correspond with periods of stronger economic growth. Bear-flattener regimes are associated with the late stages of the business cycle, when the Fed raises short-term rates and the market anticipates slowing growth and rising inflation. While both economic environments correspond with positive equity returns, the former represents a more constructive scenario.
While rising rates are positive for equities, individual sectors can exhibit a wide range of outcomes. “Equity Returns” also illustrates that when rates first start rising, cyclical sectors tend to outperform defensives, and this relationship holds during bear-flattener and bear-steepener regimes.
Given the expected strength in equities as interest rates rise, investors might work with an advisor to determine if a tactical increase in their allocation to equities makes sense given their objectives and risk tolerance. They might also consider greater allocations to cyclical sectors (financials, technology, industrials etc.) over defensive sectors using sector-focused exchange traded funds or mutual funds.
Considering that rising rates lead to falling prices for bonds, it’s understandable that some investors seek to reduce fixed income in their portfolio when rates are rising. Certain growth strategies provide a diversification benefit that can help maintain a portfolio risk and return while reducing fixed income. For qualified investors, hedge fund strategies may offer this benefit due to their exposure to different sources of return and risk that often have a low correlation to traditional asset classes.
After carefully considering an investor’s profile (liquidity, total net worth and income) and explaining the risks and terms of the investment, an advisor might recommend that an investor include hedge funds in his portfolio for greater diversification. “Benefits of Diversification,” p. 50, illustrates the correlations of several hedge fund strategies to equity and fixed income asset classes. It’s evident in Area B of this illustration that the diversification benefit of investment grade fixed income is significant. Over the past 20 years, correlations of investment grade fixed income to equity asset classes have been close to zero. This has enabled investors to achieve robust risk/adjusted returns. However, as illustrated in Area C, the correlations of most hedge fund strategies to equities and fixed income are also low enough to provide a diversification benefit. Global macro and commodity trading advisor funds, in particular, stand out as exhibiting the lowest correlations to other traditional asset classes.
In addition, many hedge fund strategies have historically exhibited less volatility (and lower returns) than equities and greater risk-adjusted returns as measured by a Sharpe ratio. Due to these characteristics, some advisors and investors may decide that a mix of hedge fund strategies can provide risk reduction through diversification.
Achieving Success
Interest rates are rising, with no clear end-target in site. Investors and their advisors want to respond to both protect capital and assure long-term growth in portfolios. Even as 10-year Treasury yields approach 3 percent, though, this isn’t our grandparents’ interest rate market, and investors can’t live off the income of their portfolios. As long as typical benchmark rates are insufficient to meet investor’s lifestyle needs, advisors and investors must work thoughtfully and closely with portfolio managers to reposition portfolios. Success requires careful consideration of the yield curve and how changes can affect different portfolio strategies. Each investor’s goals will best be met by repositioning portfolios based on rising rates, the changing shape of the yield curve and the resulting asset class strategies that best achieve the growth, capital protection and income needs of the investor.
Endnotes
1. The Federal Reserve Bank of New York, “Fedpoint: Federal Funds and Interests on Reserve” (March 2013), www.newyorkfed.org/aboutthefed/fedpoint/fed15.html.
2. Robert Kopprasch and Steven Mann, “Portfolio Management: Yield Curve Strategies,” CFA Institute (2017).
3. For example, see Christopher Dhanraj, “What the Yield Curve Can Tell Equity Investors,” BlackRock (February 2018); Steve Chen et al., “Navigating Through Rising Interest Rates: Impact for Quant Strategies,” Deutsche Bank (June 14, 2018).
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