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Portfolio > Mutual Funds > Bond Funds

Readying for Higher Interest Rates

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Testifying before Congress, new Federal Reserve Chair Jerome Powell expressed confidence in the continuing growth of the U.S. economy and a belief that inflation remains a threat. Markets took Powell’s optimism as a sign that the Federal Reserve will continue increasing interest rates in 2018 and beyond. According to former Fed Chair Alan Greenspan, we are in the latter stages of a “bond market bubble” that is “about to unwind.”

In their book, “Invest with the Fed,” American College CEO Bob Johnson, Gerald Jensen of Creighton University and Luis Garcia-Feijoo of Florida Atlantic University, investigate the impact of contractionary Fed policy on the performance of stocks and bonds. According to Johnson, “I agree with Alan Greenspan. Investors who believe that stocks are risky and bonds are safe could be in for a rude awakening.”

Signaling rising rates had a predictable effect on markets. Bond yields rose, bond prices fell, and the stock market started showing some jitters that advisors and their clients haven’t seen in months. How should advisors prepare their clients for a new era of rising bond rates? What should they tell their clients to expect in 2018 and beyond?

Go Short Term

A common strategy is to protect clients from bond losses by reducing the duration of their bond portfolio. Duration is commonly used to estimate what will happen to the value of a bond portfolio if interest rates rise by 1% (say from 3% to 4%). The average long-term bond fund in the United States has a duration of 11 years according to Morningstar. If interest rates rise by 2%, the value of the bond portfolio will fall by about 22%.

This is a big risk in the portion of a portfolio that’s generally considered low risk. And a 2% rise doesn’t seem that implausible. Gail Gill, a financial planner at Worley Erhart-Graves Financial Advisors, is leaning toward a bond strategy that favors short-term bonds (which have a median duration of about 2 years).

“When I look at interest rates, I like to think in terms of extremes. From the early 1950s to the 1980s, it looks like a straight line up. After the 1980s, it’s a straight line down. I want to be the one riding the line up,” notes Gill.

A lot of advisors have been thinking that interest rates had nowhere to go but up for a long time. “Predicting the future interest rate environment for bonds is tough,” notes David Blanchett, head of Retirement Research at Morningstar.

Risks vs. Rewards

One widely used strategy has been to reduce the risk of an inevitable increase in interest rates by moving away from longer-term bond funds in recent years, but there is a significant cost to shielding clients from risk. “Worried about rising yields, many advisors have targeted lower durations for client portfolios for years, only to see yields stay relatively low,” notes Blanchett.

While it isn’t a bad idea to keep an eye out for what might happen, this type of positioning over the last decade has resulted in lower returns than could have been achieved if clients had accepted more interest rate risk to earn a term premium.

David Nanigian, associate professor of finance at Cal State Fullerton, agrees that advisors should be not only wary of timing the market, but also sensitive to the risk of rising rates. “I don’t think that advisors should try to predict the future levels of interest rates with great precision. Even economists who forecast interest rates for a living aren’t that good at it. I also don’t think that it is sustainable for interest rates to stay as low as they are. Therefore, I think that advisors should plan for a rising interest rate environment and craft portfolio management strategies accordingly.”

Blanchett agrees that “It makes sense to think about the current rate, but only as an adjustment to the typical target duration of the portfolio. For example, if it’s normally a seven-year target, maybe drop things to five years, but don’t go to all cash.”

This strategy resonates with Jay Barclay, a financial advisor at Strategic Financial Planning. “We stay intermediate-to-short knowing that rising interest rates will be a drag on the portfolio, but the primary objective is to maintain a diversified portfolio. It’s boring, but clients like boring.”

Focusing on risk is key. “Clients are not going to hit interest rate goals from the past,” cautions David Klaus, a financial planner at One to One Financial Advisors. “I stick with core intermediate bond funds. Short-terms funds have less risk, but there’s so little return there. I’m not big on long-term bond funds because of the risk.”

In other words, shorter-term bonds (which have historically underperformed intermediate-term bonds by 2% per year) will drag down a portfolio’s performance by missing out on the term premium. Longer-term bonds could drag down a portfolio’s performance by falling in value when interest rates rise.

What to Do?

It would seem advisors don’t have any good options. However, Harold Evensky, principal at Evensky-Katz/Foldes Wealth Management, notes that even “a paltry return will look very attractive in the event of a market correction.”

One option is to invest in an oft-forgotten hedge against inflation risk — the Treasury Inflation Protected Security, or TIPS. These government bonds, whose value rises with inflation, can be an overlooked way to achieve a term premium while also hedging against inflation risk. Gill notes that “For the first time in a long time, I’m considering using TIPS.”

While TIPS don’t provide protection against an increase in real (after inflation) interest rates, few economists see any indication that real rates will rise. Demographic or productivity trends suggest a steady demand for bonds. If investors are still looking for a safe way to set money aside for future spending, sellers won’t need to offer rates of return above the rate of inflation.

Nanigian also recommends that advisors who are concerned about interest rate risk consider floating rate note mutual funds that adjust coupon payments in response to changes in interest rates. A caveat is that these funds can be risky. “They may be subject to large downside risk in the event of a ‘fire sale’ by fund shareholders,” he says.

Cash-Flow Matching

For those who are saving for a specific goal, such as spending in retirement, matching the payout of the bond to the spending need can insulate the investor from cash flow volatility. Nanigian says that an advisor can create a “cash flow matching” portfolio by “constructing a client’s portfolio such that the anticipated cash inflows (from principal and interest) match the anticipated income needs of the client.”

The downside of cash flow matching is that bonds held within a portfolio will still fall in value if interest rates rise even if they aren’t sold until maturity. And cash flow matching using nominal bonds provides no protection against inflation. However, it does ensure that a client will be able spend a specific amount of future dollars without worrying about what happens in the market.

The risk of a spike in interest rates is less of a worry for clients who hold a significant amount of cash value in a life insurance policy, says James Brocke, a financial planner at MassMutual Midwest. This is because some institutions can smooth bond returns across generations of policyholders to reduce annual return volatility. In my own recent research, I’ve estimated that this smoothing can be particularly beneficial for a new retiree in preserving their ability to fund a spending goal into old age.

And it’s not just life insurance that provides this smoothing value. Many workers have the option of investing in a stable value fund within their retirement accounts. These stable value funds are constructed to shield bond investors against losses while providing a higher return than cash. The downside of stable value funds is that they often have a shorter duration and have underperformed longer duration bonds historically.

Strategies for a Rising-Rate Environment

Interest rate cycles do indeed tend to be long-term mean reverting. They go up for a couple of decades and go down at the same rate. It’s been a long time since interest rates have risen, so it’s worth studying what happens to asset returns when the Fed decides to start raising rates.

Between 1960 and 1980, long-term bonds got trounced. They provided an average annual return of 1.9% and a standard deviation of 6.56%. Short-term bonds averaged a return of 3% with a standard deviation of only 2.35%. This is a reminder that even though long-term bonds have outperformed historically, they can underperform for a long time, all the while punishing investors with more than twice the volatility of short-term bonds.

One asset with returns that resemble a long-term bond that has performed well in a rising rate environment is equity real estate investment trusts, or REITs. Johnson has estimated that equity REITs had an annualized return of 9.8% when rates were rising. Mortgage REITs are another story. He estimated that mortgage REITs fell by an average of 4.1% per year in a rising rate environment.

Rising rates can do a number on a well-diversified portfolio of both bonds and stocks. According to Johnson, “Historically the overall equity market has performed dramatically better when interest rates were falling than when rates were rising ,and I see no reason to expect any different relationship moving forward.” In his research, he found that from 1966 through 2016, the S&P 500 returned 15.2% when rates were dropping and only 5.8 % when rates were increasing.

Some stocks are particularly prone to under-performing in a rising rate environment. Johnson notes that “small firms have struggled during a rising rate environment and the well-documented “small firm effect” has been concentrated in falling interest rate environments. Investors may want to lighten their small firm exposure in anticipation of a secular rising interest rate trend.”

The Good News

What investments have performed well when interest rates rise? Sectors whose business model is not dependent on consumer borrowing, such as energy, utilities and consumer staples like food products, do just fine. Sectors such as autos, construction and retail tend to underperform.

Energy, utilities, consumer goods and food outperformed in rising rate environments. On the other hand, apparel, retail, autos and construction outperformed in falling rate environments. “This makes sense as people need to put gas in their automobiles, heat and cool their homes, brush their teeth, and eat, whether rates are moving up, down or sideways,” notes Johnson.

A particularly attractive asset class during a rising rates environment is commodities. Johnson’s research finds that the Goldman Sachs Commodity Index returned 17.7% annually during rising interest rate environments, while losing 0.2% annually during falling rate environments. The one exception is gold, which has proven a surprisingly ineffective hedge against interest rate risk in the past.

In addition to commodities, emerging markets (with economies that are often commodity-based) can become a more attractive. “If one is looking for global exposure, emerging market equities have historically outperformed developed market equities during rising rate environments,” notes Johnson.

Although it has been a long time since we’ve seen a push toward rising rates by the Federal Reserve, there are a number of lessons from history that can help advisors guard against the risks of a rising rate environment. Moving toward sectors that have proven effective shelters against the storm of higher interest rates can be a sensible strategy.

Michael Finke is head of The American College on Financial Planning and a regular contributor to Investment Advisor.


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