Investing in an environment of rising interest rates is a high-wire act. While bonds are paying more, their prices will continue to get smacked down until the cycle peaks. When that will be is the great unknown, making fixed-income investing a game that is part guesswork and part dollar-cost averaging.
The last two times the Federal Reserve went into tightening modes, in 1994 and 1999, the Lehman Brothers U.S. Aggregate Bond Index took it on the chin. Excluding coupon returns, the index ended the years down 9.5% in 1994 and 7% in 1999. The prospect of this happening yet again is sending some investors fleeing. In May, according to Lipper, investors yanked a net $17.5 billion from bond funds–the largest ever recorded by the fund tracking service.
Although nerves are on edge in the bond market, rising rates aren’t likely to treat equity investors much better. The S&P 500 rose a paltry 1.3% in 1994. To be sure, bubble-happy equity investors kept the party going in 1999 despite continuous rate increases, with the S&P ending the year up 20.9%. But what followed for the next three years was as ugly as it gets. “Between the Fed first pronouncing fear of deflation, then turning 180 degrees and sounding inflation alarms,” explains Mark Forster, portfolio manager at Kirr Marbach, an Indiana-based asset manager, “it’s easy for advisors and investors to get paralyzed by mixed signals, especially as prices and interest rates rise, oil prices blow past record levels, and geopolitical uncertainty mounts.”
However, the sheer fact that rates are going up doesn’t inherently mean trouble for investors. The Fed is responding to inflation amid signs of renewed economic growth. This means that more people are working, pricing power is returning to corporations, and profits are rising. Even if the Fed pushes up rates by 200 basis points by the end of 2005–which is the general consensus–they will still remain at growth-sustaining levels. A recent survey of 34 economists by Business Week concluded that higher rates may not be a big issue because “low-cost financing and strong sales growth have left companies so flush they don’t need to borrow much.”
So why all the nervousness over rates? It’s simple: Over the short term, at least, making money as rates begin to rise can be very difficult. According to Sam Stovall, S&P’s chief investment strategist, stocks don’t do very well for six to 12 months after a series of rate hikes is initiated. Citing six periods of rising rates since 1970, Stovall found that the broad market fell an average 5% in the six months after initial monetary tightening began. After a year, the index was off an additional percentage point. A few sectors did hold up: In the 12 months following the start of a cycle of rising rates, for example, information technology rose an average of 7%. Health care wasn’t far behind, climbing 5%. But Stovall found that 55 of the 56 industries tracked by S&P fell during the first six months, suggesting that no one will escape the reckoning unscathed this time around.
Despite the likelihood of rough sailing in coming months, advisors shouldn’t be making radical asset reallocations. “A well-balanced portfolio,” says Steven Saker, VP of International Asset Advisory in Orlando, Florida, “should be designed to roll with changing interest rates as they cycle through periods of economic contraction and expansion.” He notes, however, that at the same time, “advisors should always be mindful of making course adjustments as new risks and opportunities present themselves.” Following are several course-correcting strategies that may help advisors sidestep some of the hazards of a rate rise, and in a few instances, even exploit it. As is common with most recommendations, phasing into positions through dollar-cost averaging should further mitigate risk.
Scaling the Ladder
While producing modest yields, shorter-term paper will have minimum volatility due to pending repayment. A consistent flow of maturities lets you reinvest in higher-yielding debt. While potentially more price sensitive, exposure to longer-term debt as rates climb will help pump up a portfolio’s average yield.
With yields already shifting dramatically, deciding when to keep one’s powder dry and when to invest will significantly affect total returns. This is no easy trick. Based on past rate cycles, Raymond Dalio, president of Bridgewater Associates, a Westport, Connecticut, investment management firm, expects Federal fund rates to peak at 4.25% and 10-year yields to top out at around 5.75%. He thinks these levels will be sufficient to slow down economic expansion without threatening growth. So he will phase his investments as rates approach these targets.
Are TIPS Too Pricey?
Treasury Inflation-Indexed Securities, popularly known as TIPS, appear to take a lot of the guesswork out of timing the market. Presuming that inflation is on the rise, TIPS will capture the change in CPI within its principal, helping the bonds to sustain their value despite rising rates. Though the coupon remains constant, increasing bond value helps generate higher yields.
Since their inception in 1997, TIPS have performed well in both bear and bull markets. The Lehman Brothers TIPS Index outperformed every other major bond and stock index during the equity bear market of 2000-2002, enjoying total annualized returns of 12.49%. Even after stocks and bonds rallied last year, the index sustained its three-year annualized lead through 2003.
Bill Davison, managing director at the Hartford Investment Management Company, which has $830 million invested in TIPS, found that for the year through June 22, total returns on four-year fixed-rate Treasuries declined 83 basis points due to rising rates. Comparably maturing TIPS were up 1.9%, or 190 basis points, because of the inflation accrual and greater price stability. Believing inflation and 10-year Treasury yields are likely to rise an additional 100 basis points over the next 12 months, to 3.75% and 5.75%, respectively, Davison thinks TIPS will continue to provide some protection.
However, some other managers think that TIPS have become too expensive. Because they offer inflation protection, TIPS coupons are normally less than those on conventional Treasuries. The difference is referred to as a breakeven inflation rate, or BEIR. According to Barclays Capital, the BEIR on 10-year issues continues to expand, from 2.50% in April to 2.67% in June. This means that inflation has to average above this rate over the lifetime of the bond for the TIPS investor to come out ahead of the investor in conventional Treasuries, which feature no inflation adjustment. But Varun Mehta of the Milwaukee-based Mason Street Advisors Select Bond Fund is currently phasing out his position in TIPS after a very good run. He doesn’t believe their returns will continue to outperform those of conventional Treasuries.
If you think yields of the 30-year Treasuries are going up, Rydex’s Juno Fund and ProFunds’ Rising Rates Fund offer you a way to profit. They do this by selling Treasuries short.
Investor interest in 10-year old Juno (RYJUX) has recently exploded, with assets rising from less than $100 million in 2002 to more than $3 billion in June. “Although created for market timers and speculators,” explains fund manager Anne Ruff, “financial advisors increasingly rely on the fund to protect unrealized bond profits that have accumulated over the past several years.”
For the year through May, S&P estimates that the fund climbed 1.29%, bettering the Merrill Lynch Corporate & Government Master Index by 1.87 percentage points. However, over the past three and five years, a period when rates were largely declining, the fund has significantly underperformed the broad bond index.
Juno has some major costs to overcome just to break even. When shorting a Treasury, explains Ruff, the fund must pay the owner of a bond the current yield, which on the 30-year issue was 5.38% as of late June. This was partially offset by keeping assets in an overnight repurchase account, which was paying 1.85% at the time. The net expense of carrying the trade was, therefore, 3.53%. Add to that the fund’s annual expenses of 1.41%, and that means the fund must earn virtually 5% before investors are in the money. Ruff estimates that a rise of 0.35 percent in the 30-year Treasury’s yield is necessary to cover investor expenses.
ProFunds Rising Rates Opportunity Fund (RRPIX), meanwhile, is a leveraged, more risky version of the Rydex fund, providing 125% inverse exposure to 30-year Treasuries. This means that the fund should appreciate 1.25 times the amount that Treasuries decrease. Barely two years old, with $679 million in assets, the fund through May was up 1.56% for 2004, outperforming the Merrill bond benchmark by 2.14 percentage points. Given the costs inherent in shorting Treasuries, the fund’s 1.57% expense ratio further raises the hurdle. But if one suspects that interest rates are going to return to their historical mean, both funds will provide a unique means of profiting from rising rates. However, once rates start coming down, you won’t want to be in either of these funds.
Opportunities in Big Caps
An alternative to shying away from the equity market is to gain exposure to a few stocks that have the strength to meet the turbulence of higher rates head on. There aren’t many that fit this bill. But consistent with S&P’s findings that technology and health care have been the top-performing industries when rates rise, companies like eBay and Stryker are likely candidates.