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.
For those who are saving for a specific goal, such as spending
in retirement, matching the payout of the bond to the spend-
ing need can insulate the investor from cash flow volatility.
Nanigian says that an advisor can create a “cash flow match-
ing” 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 spe-
cific 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
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 mov-
ing forward.” In his research, he found that from 1966 through
2016, the S&P 500 returned 15.2% when rates were rising and
only 5. 8 when rates were falling.
Some stocks are particularly prone to underperforming 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.