In 1980, then Federal Reserve (Fed) Chair Paul Volker pushed short-term interest rates to more than 20 percent in an effort to help tame rampant U.S. inflation, which had been as high as 14 percent in a single year. Since then, interest rates have been generally falling, with short periods of rate increases, and inflation has remained contained. The Fed held short-term rates near zero percent from 2009 until 2015. Now, the Fed is embarking on normalizing short-term interest rates, and many expect the United States is moving back to an environment of increasing long-term rates. Some investors are concerned that investments in their portfolio may be damaged during a period of rising rates and are seeking strategies to help meet projected needs and goals.
We recommend you take three key steps to evaluate and manage your potential risks during this expected period of increasing interest rates.
- Evaluate your current objectives and needs to ensure they are up-to-date. Evaluate your goals for income, as well as your ability to tolerate risk or variability of returns that may occur in your portfolio.
- Give your portfolio a thorough check-up. While it may be that no adjustments are necessary, your sensitivity to two key risk areas should be reviewed: 1) duration, which is a measure of the sensitivity of an asset to changes in interest rates, and 2) credit, which involves the sensitivity of an asset to default or the failure of a bond issuer to make agreed-upon payments. Adjust portfolio exposures to account for these risks and take a look at history for a guide on potential portfolio tilts to help manage your risk exposures.
- Ensure your portfolio remains appropriately diversified after your check-up. While a rising rate environment appears likely in the coming quarters, portfolio strategies should account for the possibility that the future may not unfold exactly as we expect.
Included in this paper is additional information about these three steps that you may want to consider.
The ups and downs of interest rates
The United States is emerging from an extended period of low interest rates. The Fed had lowered interest rates for bank borrowing in response to the financial crisis, in an effort to make loans more affordable and attractive and to help stimulate economic growth. However, we may now be entering a period of rising rates. In a rising rates period, the Fed does the opposite of what occurred during the financial crisis, by incrementally increasing the cost of borrowing for banks and leading the bond market to higher short-term rates. Whenever new bonds are issued that offer higher yield, the price of comparable existing bonds declines, so rate increases naturally have a negative effect on existing bond prices.
The Fed typically increases rates in order to cool a growing economy and prevent excessive inflation. One former Fed Chairman described his unpleasant duty of raising rates by saying, “The Federal Reserve is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”1
After having endured the financial crisis and being able to finally breathe a sigh of relief due to a stable, growing economy, it’s no wonder why many investors feel uncertain about the future. Many may be wondering, “Without the punch bowl, what will happen to my portfolio?” While the future is never certain, there are steps investors can take to assess their portfolio in light of the likelihood for rising rates ahead, and take action if necessary.
Step 1: Evaluate your current objectives and needs
Investor goals vary. In addition, different investments can be more or less attractive depending on how well they serve to help meet an investor’s goal. Aside from the potential short-term opportunities and risks that may occur during different market periods, for long-term investors it is important to reflect on the two primary reasons for holding bonds in a portfolio. One reason may be to help generate reliable income from the bond coupon payments. It is important to also recall that high quality bonds that do not experience a default still mature at par, regardless of whether prices decline prior to maturity due to higher interest rates. Said another way, for buy-and-hold investors with a long time horizon, the total holding period return is not impacted by changes in interest rates. Rather, near-term price declines are offset by price increases at a later date as the bonds approach maturity.
The following chart shows the yield of a variety of investments. A blend of income-producing assets is attractive to many investors who want to receive regular cash flow from their portfolios while remaining diversified. It is important for investors to confirm whether the income produced from portfolios is the right amount in order to help achieve goals, while also considering the portfolio’s risk parameters.
Yields on commonly used income-generating investments
Source: Morningstar. Data: as of 4/30/17. *TEY = tax equivalent yield (assuming income tax rate of 39.6%). Benchmarks used to illustrate yield are shown in the disclosures section.
The second primary reason to own bonds is the diversification benefit that results from owning assets that move differently than one another within a single portfolio. This relationship is referred to as correlation. The table on page 3 shows the correlation of returns generated by common investment types. A high correlation indicates that the investments have a similar return pattern and a negative correlation indicates an offsetting or inverse relationship between returns. Blending assets with low or negative correlations with one another has the potential to help smooth the ups and downs of a short-term asset price movement, and generate attractive portfolio level returns relative to the risks incurred. For example, historically, U.S. equities tend to perform well when U.S. Treasury, high quality corporate and municipal bonds are not performing well, and vice versa. We believe it is important for investors to confirm they have an appropriate mix of complementary assets in order to potentially reduce overall portfolio return volatility.
Performance behavior between common investment types
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Source: Morningstar. Data: 1/01/94-3/31/17. Information about index benchmarks used as asset class proxies is included in the disclosures section.
Perhaps the most important issue for investors to consider, even in a rising rates environment, is whether their overall investment objective has changed. If your need for income distributions or your appetite for risk has changed, we recommend discussing the changes with your investment professional and taking time to review your entire portfolio in light of that new profile, not just in response to a rising rate environment. If your investment objective has not changed, then consider adjusting — not abandoning — your long-term plan, in light of rising rates.
Step 2: Give your portfolio a thorough check-up
Once your long-term goals are confirmed, you can examine your individual investments in light of their potential behavior during a period of rising rates to consider whether any adjustments could help in the short term. Many investors, upon expecting rate increases, may be tempted to react in an extreme way, such as eliminating fixed income altogether in favor of cash or equities. However, understanding the factors at work in a portfolio and evaluating all investments during a rising rate period can help you identify moderate adjustments that may help retain your long-term goals of income and portfolio stability.
Review two key risk factors: duration and credit. There are two key factors at work that make fixed income investments more or less attractive during rising rate periods: duration risk and credit risk.
Duration describes how sensitive a bond’s price is to interest rate changes. Bonds with fixed coupon payments and a longer term to maturity are more sensitive to interest rate changes, experiencing larger price declines when rates rise (and larger price increases when rates fall) when compared to bonds with a shorter term to maturity. Bonds with a floating coupon payment, which adjust periodically depending on interest rates, have less price sensitivity to interest rate changes, even when they possess longer terms to maturity.
Credit risk refers to the risk that the bond issuer is unable or unwilling to repay their debt, which creates the potential for an investor to lose income or principal. Bonds with more credit risk typically generate higher returns via higher coupon payments, but also have higher risk. As long as the economy, and by extension the company that issued the bond, is doing well, the higher coupon payment can serve to cushion the impact of duration risk due to rising interest rates.
Pulling the levers of duration and credit risk in your portfolio. Managing these risks in portfolios involves a complex analysis of trade-offs. Reducing duration risk can be as simple as selling bonds that have a long time until maturity and buying bonds that will mature much sooner, or selling fixed rate bonds and buying floating rate bonds. However, this likely comes at a cost of reducing the cash flow from your bonds, which may not be desirable. Similarly, you can increase your credit risk to add income to your portfolio, but by doing so, the probability of losses increases in rocky economic times. Generally, we believe a moderate approach may be the most appropriate policy in adjusting your portfolio exposures to help manage these risks.
Look to history for guidance. While past performance isn’t a guarantee of future results, it can be helpful to look at the historical performance of various assets during periods of Fed rate increases. In the following table, the performance of asset types is shown over recent periods of rising rates. During periods when the Fed is raising rates, stocks and commodities have had returns close to or above those experienced by the long-term average. During these periods, bonds have underperformed.
Performance of commonly held asset types during current and prior three Federal Reserve rate increase periods*
Performed consistently above long-term average
U.S. equities (Financials), developed foreign equities, commodities
Performed slightly below or above long-term average
U.S. equities, high dividend U.S. equities
Performed consistently below long-term average
Core bonds, government bonds, intermediate and long-term bonds, municipal bonds
*Compared to the long-term average performance for the entire period 1/1/94-4/30/17.
Source: Morningstar, St. Louis Federal Reserve.
It is important to note that while these dates indicate periods when the Fed deliberately increased rates, there are many other factors that also impact investment prices, such as market or business fundamentals and economic or policy events and trends. For example, the market may anticipate a rate increase from the Fed and reflect that expectation in bond market prices and rates although the actual increase ultimately does not materialize as predicted. In other cases, a short-term event may cause a “flight to quality” in which investors sell their riskier assets (stocks and bonds with a high degree of credit risk) in favor of safer bonds, such as Treasuries or investment grade corporates and municipals.
While each time period analyzed has its own unique characteristics, we observe two key conclusions. First, most types of bonds tended to be negatively impacted during rising rate periods. In particular, high quality bonds with a long time until maturity tended to suffer larger price declines. Second, certain types of stocks (and even commodities) tended to perform better-than-average during these periods. A common driver for this may be inflation, which can benefit corporate pricing power, and therefore, corporate earnings, while pushing interest rates higher, thus bond prices lower. We believe this data supports the need to have a discussion with your investment professional.
Step 3: Ensure your portfolio remains diversified
Economic data indicates solid growth and strong employment, which we see as evidence for the Fed to persist with further interest rate increases. The Fed could accelerate rate increases if inflation expectations rise. Alternatively, they could reduce or postpone further increases if economic activity slows more than expected, in the event of a geopolitical crisis, or if inflation remains too low. Rather than try to precisely predict the Fed’s next move, we recommend looking at the big picture, understanding that as we enter a period of rising rates, there are clear actions that can be taken as a result of the punch bowl being removed.
Re-evaluating your goals, including your need for yield and your risk tolerance, assessing the risk and reward of different investments during rising rate periods, and considering careful portfolio adjustments in line with those goals are great steps to consider in the new environment. Making moderate, thoughtful adjustments allows you to remain diversified while acknowledging the current market opportunities and risks.
There are three steps investors may want to consider to help manage portfolio risk as we potentially face a rising interest rate environment. First, review and affirm your current investment goals. When assessing your goals, look specifically to evaluate your income needs and risk tolerance. Second, perform a portfolio check-up, with particular attention paid to duration and credit risk. Also, consider market history while reviewing the “tilt” in your portfolio during a rising interest rate environment. Finally, assess your portfolio adjustments for sufficient diversification. With a well-diversified portfolio that combines consideration of your goals with the current market environment, you will be better prepared to face the potential for rising rates.
1 Martin, William McChesney and Board of Governors of the Federal Reserve System (U.S.), 1935- “Address before the New York Group of the Investment Bankers Association of America.” October 19, 1955, https://fraser.stlouisfed.org/scribd/?item_id=7800&filepat
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This information was developed in July 2017, and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.
Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Diversification and asset allocation do not guarantee returns or protect against losses.
Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. In the illustrated charts and tables, performance of various asset classes is represented by: Municipal bonds: Bloomberg Barclays U.S. Municipal Bond Index measures the investment grade, U.S. dollar denominated fixed tax exempt bond market and includes state and local general obligation, revenue, insured and pre-refunded bonds. Core bonds: Bloomberg Barclays Aggregate Bond Index measures the investment grade, U.S. dollar denominated, fixed rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. Long-term corporate bonds: Bloomberg Barclays Long-Term Corporate Bond Index contains investment grade fixed rate U.S. corporate bonds that have $250 million or more of outstanding face value and have maturities greater than or equal to 10 years. Short-term U.S. Treasury bonds: Bloomberg Barclays Short Treasury 9-12 Index contains U.S. Treasury bills with maturities between nine to 12 months. Long-term U.S. Treasury bonds: Bloomberg Barclays Long-Term U.S. Treasury Index contains U.S. bonds that have $250 million or more of outstanding face value and have maturities greater than or equal to ten years. High yield bonds: BofA Merrill Lynch U.S. High Yield Master II Index is a commonly used benchmark index for high yield corporate bonds and measures the broad high yield market. Developed foreign bonds: Bloomberg Barclays Global Treasury ex-U.S. Index includes government bonds issued by investment grade countries outside the United States, in local currencies, that have a remaining maturity of one year or more and are rated investment grade. Emerging market bonds: JP Morgan Emerging Markets Bond Index Global tracks total returns for traded external debt instruments in the emerging markets. Foreign large core equities: MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). Emerging market equities: MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. High yielding U.S. equities: Dow Jones Select Dividend Index universe is defined as all dividend-paying companies in the Down Jones U.S. Total Market Index that have a non-negative historical five-year dividend-per-share growth rate, a five-year average dividend earnings-per-share ratio of less than or equal to 60 percent and three-month average trading volume of 200,000 shares. U.S. equities: S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. Domestic real estate: Dow Jones Select REIT Index intends to measure the performance of publicly traded REITs and REIT-like securities. Commodities: Bloomberg Commodity Index tracks prices of futures contracts on physical commodities in the commodity markets and is designed to minimize concentration in any one commodity or sector.
In the illustrated charts and tables, proxies used to show historical yield of various asset classes are represented by: Municipal bonds: iShares National Muni Bond ETF seeks to track the investment results of an index composed of investment-grade U.S. municipal bonds. Corporate bonds: iShares 10+ Year Credit Bond ETF seeks to track the investment results of an index composed of long-term, investment-grade U.S. corporate bonds and U.S. dollar-denominated bonds, including those of non-U.S. corporations and governments, with remaining maturities greater than 10 years. Core bonds: iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment grade bond market. 20-year Treasury bonds: iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than 20 years. Emerging markets bonds: iShares J.P. Morgan USD Emerging Markets Bond ETF seeks to track the investment results of an index composed of U.S. dollar-denominated, emerging market bonds. High yield bonds: iShares iBoxx $ High Yield Corporate Bond ETF seeks to track the investment results of an index composed of U.S. dollar-denominated, high yield corporate bonds. Foreign large core equities: iShares Core MSCI EAFE ETF seeks to track the investment results of an index composed of large-, mid- and small-capitalization developed market equities, excluding the United States and Canada. High yielding U.S. equities: iShares Select Dividend ETF seeks to track the investment results of an index composed of relatively high dividend paying U.S. equities. Domestic real estate: Vanguard Real Estate Investment Trust (REIT) ETF which invests in stocks issued by REITs, companies that purchase office buildings, hotels and other real property. Goal is to closely track the return of the MSCI U.S. REIT Index, which is a gauge of real estate stocks.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Exchange-traded funds (ETFs) are baskets of securities that are traded on an exchange like individual stocks at negotiated prices and are not individually redeemable. ETFs are designed to generally track a market index and shares may trade at a premium or a discount to the net asset value of the underlying securities.
© 2017 U.S. Bank (7/17)