How to prepare portfolios for rising interest rates

Historical data helps identify assets that may be positioned to fare well when higher rates threaten fixed-income and equity returns

For a good illustration of how investors typically react to the prospect of higher interest rates, look at what happened in January 2022. News that the US Federal Reserve (Fed) might begin raising rates as early as March sparked market volatility that helped to drive general US stocks to their worst monthly performance since March 2020. Bond prices also fell, with yields on the 10-year Treasury recording their largest monthly increase since March 20211

Now, with higher interest rates widely expected, many investors are worried about the potential impact on their investments — and wondering how they should prepare their portfolios.

Now, with higher interest rates widely expected, many investors are worried about the potential impact on their investments — and wondering how they should prepare their portfolios. For insights, we can examine how different asset classes have performed during previous periods of rising interest rates. 

Our research into the past four Fed rate hike cycles (2015, 2004, 1999 and 1994) suggest that high-yield bonds, factors such as value and quality, and natural resources investments may be well positioned for stronger returns during rising-rate environments. 

FIXED INCOME: WATCH DURATION AND CONSIDER HIGH-YIELD BONDS

Because rising interest rates hurt the prices of existing bonds, investors are likely to focus on the potential interest rate risk in their fixed-income allocations. During Fed tightening cycles, the market has historically anticipated rate increases and prices them into the bond market before they happen. Yet there’s always uncertainty about the timing, size, and number of rate hikes, which may create additional volatility if actual rate hikes don’t match the market’s expectations.

Managing duration in a fixed-income portfolio is one way to address this uncertainty. Our research has found that duration is responsible for the majority of expected returns in fixed-income assets, and bonds with shorter durations are often less sensitive to rising interest rates. So, in rising rate environments, positioning fixed-in¬come holdings on the shorter end of the duration curve may reduce risk.

So, in rising rate environments, positioning fixed-income holdings on the shorter end of the duration curve may reduce risk.

However, shorter duration bonds also tend to have lower yields, which may not support investors’ income goals. In these cases, investors might consider taking on additional credit risk in an effort to potentially boost their portfolio’s yields. Our research shows that historically the high-yield segment of the fixed-income markets has performed well during periods of rising interest rates:

p2_RisingInterestRates_High Yield Boxes

It’s also important to look at underlying economic fundamentals and technical issues of supply and demand when considering an allocation to high-yield bonds. In early 2022, strong balance sheets have helped keep defaults low among high-yield issuers. At the same time, our research shows that issues of roughly half of all high-yield bond maturities had been extended to 2028 and beyond, potentially reducing the likelihood of new issuances that could hurt the prices of existing high-yield bonds. 

EQUITIES: FOCUS ON VALUE, QUALITY, AND DIVIDEND YIELD

Just as duration helps determine a bond’s sensitivity to rising rates, you can use a similar concept to assess the potential performance of different types of stocks. Equity investors are essentially paying today for a company’s future cash flows and earnings. The farther off those cash flows and earnings are, the longer the stock’s “duration” — and the greater the risk that higher inflation will hurt that stock’s performance.

But when interest rates rise, the value of those future earnings in today’s dollars may decline.

Think of a fast-growing technology company: Investors may pay high multiples today in anticipation of higher cash flow and earnings in the future. But when interest rates rise, the value of those future earnings in today’s dollars declines. That’s one reason why technology stocks and other growth equities tend to be more volatile in rising rate environments.

Given these characteristics, we believe natural resources are the most attractive of the real asset categories as investors anticipate higher interest rates.

In contrast, certain classes of equities may not suffer as much when interest rates increase, due to their shorter “duration.” Our research has found that factors such as value, quality, and dividend yield look attractive in rising rate environments: 

p3_RisingInterestRates_Factor return Boxes

This data can’t guarantee how stocks will perform in every rising rate scenario. But we believe that diversifying equity holdings across multiple factors may help manage the impact of interest rate hikes better than an equity allocation concentrated in large growth stocks. 

REAL ASSETS: CONSIDER NATURAL RESOURCES

Many investors hold real assets for their inflation-hedging potential, but it’s important to recognize that not all types of investments in the real assets category respond to the same macroeconomic factors. Real estate and infrastructure investments, for example, carry interest rate sensitivity that may hurt their returns when rates rise. 

In contrast, natural resources investments typically haven’t suffered when interest rates increase. Instead, their returns have historically been more sensitive to changes in the equity markets and economic growth prospects, particularly in emerging markets. In fact, natural resources provided the highest one-year returns of the major asset classes during the past four Fed rate hiking episodes, averaging 25.0%7

Given these characteristics, we believe natural resources are the most attractive of the real asset categories as investors anticipate higher interest rates. There is some risk that rising interest rates could slow economic growth and negatively impact natural resources investments, but we believe that the Fed will pause its rate hikes before reaching that point.

The key to helping clients navigate these periods is to pre-position portfolios for potential interest rate changes before they happen.

A DIVERSIFIED APPROACH TO MANAGING INTEREST RATE RISK

The exact timing and magnitude of any rate increase is always uncertain, and the impact of rising rates can show up in many parts of a portfolio. The key to helping clients navigate these periods is to pre-position portfolios for potential interest rate changes before they happen. 

Looking at potential interest-rate sensitivity across fixed-income and equity allocations can help ensure your clients are exposed to assets that are more likely to withstand the pressures of rising rates — but that are still well diversified to manage the market’s reactions should future rate movements not match expectations.


DEFINITIONS

Duration is a measure of the sensitivity of the price of a fixed-income investment to a potential change in interest rates.

Bloomberg High Yield 2% Capped Index is an issuer-constrained version of the Bloomberg US Corporate High-Yield Index that measures the market of USD denominated, non-investment grade, fixed-rate, taxable corporate bonds.

Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below.

Bloomberg Aggregate Bond Index broadly tracks the performance of the U.S. investment-grade bond market is designed to represent the full range of investment-grade bonds traded in the U.S. It is composed of more than 10,000 issues.

MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 602 constituents, the index covers approximately 84% of the free float-adjusted market capitalization in the US.

Value factor distinguishes between value stocks and growth stocks using the ratio of book-value of equity to market capitalization.

Quality factor utilizes the Northern Trust approach that attempts to measure companies that have sustainable competitive advantages and have generated sustainable shareholder value over time. We do this by measuring characteristics including strong profitability, consistent and strong levels of cash flows, and prudent deployment of capital by an efficient management team.

Dividend factor computes a predicted dividend yield using the past history of dividends and the market price behavior of a stock.

S&P Global Natural Resources Index includes 90 of the largest publicly-traded companies in natural resources and commodities businesses that meet specific investability requirements, offering investors diversified and investable equity exposure across three primary commodity-related sectors: agribusiness, energy, and metals & mining.


FOOTNOTES

1 Bloomberg, 10-Year Treasury Rate, March 1, 2021 – January 31, 2022.

2 Source: Bloomberg. Comparison of the Bloomberg Aggregate Bond Index (Agg) performance and the Bloomberg Barclays High Yield 2% Capped Index returns for four full year time frames of 1994, 1999, 2004, and 2015. Indexes are unmanaged and cannot be invested in directly. Index performance does not reflect any fees or expenses. Performance of an index is not illustrative of any particular investment. Past performance does not guarantee future results.

3 Source: Bloomberg. Comparison of the MSCI USA Index performance and the Bloomberg High Yield 2% Capped Index returns for two full year time frames of 2004 and 2015. Indexes are unmanaged and cannot be invested in directly. Index performance does not reflect any fees or expenses. Performance of an index is not illustrative of any particular investment. Past performance does not guarantee future results.

4 Source: Bloomberg. Comparison of the MSCI Barra “Value” factor index versus the MSCI USA Index performance returns for four full year time frames of 1994, 1999, 2004, and 2015. Indexes are unmanaged and cannot be invested in directly. Index performance does not reflect any fees or expenses. Performance of an index is not illustrative of any particular investment. Past performance does not guarantee future results.

5 Source: Northern Trust & Bloomberg. Comparison of the Northern Trust “Quality” factor index versus the MSCI USA Index performance returns for four full year time frames of 1994, 1999, 2004, and 2015. Indexes are unmanaged and cannot be invested in directly. Index performance does not reflect any fees or expenses. Performance of an index is not illustrative of any particular investment. Past performance does not guarantee future results.

6 Source: Northern Trust & Bloomberg. Comparison of the MSCI Barra “Dividend Yield” factor index versus the MSCI USA Index performance returns for four full year time frames of 1994, 1999, 2004, and 2015. Indexes are unmanaged and cannot be invested in directly. Index performance does not reflect any fees or expenses. Performance of an index is not illustrative of any particular investment. Past performance does not guarantee future results.

7 Source: Bloomberg. S&P Global Natural Resources Index performance returns for four full year time frames of 1994, 1999, 2004, and 2015. Indexes are unmanaged and cannot be invested in directly. Index performance does not reflect any fees or expenses. Performance of an index is not illustrative of any particular investment. Past performance does not guarantee future results.

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