Investing in a rising rate environment

The U.S. economy has gone through a dramatic shift over the last four decades and one trend stands out above the rest, a strong and steady decline in interest rates. The 10-year Treasury yield went from over 15% in 1981 to an all-time low of .52% in August of 2020 (see chart below). Over the same period, the federal funds rate has fallen from 20% to nearly zero and the 30-year fixed mortgage rate has dropped from over 18% to below 3%.

As we sit here today, the S&P 500 is trading near all-time highs and the median home price in the U.S. is the highest it has ever been. This might be hard to believe when we look back to March 23, 2020 when the S&P 500 had just dropped almost 34% in 30 days. But with the economic uncertainty that resulted  from the COVID-19 pandemic came record stimulus from the U.S. Government and Federal Reserve, including significant bond purchases. This pushed up bond prices, leading to a significant decline in interest rates.

Since bottoming in the second half of 2020 the 10-year yield has since spiked to over 1.7%. This recent rise in rates is likely due to expectations of higher-than-expected economic growth, as some investors are worried that additional stimulus could jump start inflation. While not overly concerning in the short-term,  a sustained rise in rates makes it more difficult to borrow, lend, and raise capital. This can create challenges for businesses to grow, invest, and meet their financial projections and for individuals who face increased borrowing costs and the potential for higher priced goods.

What does a sustained rise in interest rates mean for your investment portfolio? While we have seen a strong and steady decline in rates since 1981, there have been many short-term rising rate periods during this time. The table below shows how different asset classes have performed during various periods when  the 10-year yield rose by more than 1%. The average length of the periods we examined was approximately 19 months, with an average increase in rates of about 2%.

Fixed Income

Bonds are typically hit the hardest during periods of rising interest rates, as their fixed payments become less attractive relative to new issues, resulting in a decline in price. Investors should focus on the overall duration (sensitivity to interest rates) of their bond portfolio since longer term maturity bonds are impacted the most. Shorter maturity bonds on the other hand are less impacted and help reduce the portfolio’s sensitivity to interest rates. The average returns of the Bloomberg Barclays Govt/Credit 1-3 Yr  Index, Bloomberg Barclays Agg Index (duration of ~6 years), and the Bloomberg Barclays Us Gov/Credit  Long Index (duration of ~13 years), were 3.9%, 2.2%, and -2.1%, respectively.

Floating rate corporate loans

To reduce the overall sensitivity to changes in interest rates within a bond portfolio it might make sense  to consider an allocation to floating rate corporate loans. Compared to traditional fixed rate bonds, their coupon rate adjusts or “floats” with the market rate, providing investors with additional yield when  interest rates rise. The average return of the S&P/LSTA Leveraged Loan Index over the five periods of  available data was 22.7%. More impressively, there were no negative returning periods.

Equities

Contrary to what some believe, stocks typically perform well during periods of rising interest rates. While  rising rates can create some uncertainty and headwinds as companies decide how to borrow and invest  capital, it typically coincides with stronger economic growth. The average return of the S&P 500 Index during the periods we looked at was 32.9%, with no negative time frames. Returns were even better outside of the U.S. with the MSCI ACWI ex USA Index returning 42.3% on average over six periods.

U.S. REITs

On the surface it might seem that rising interest rates are bad for Real Estate Investment Trusts (REITs),  since an increase in rates leads to higher borrowing costs. While this can be true in the short-term, if a rise in rates is followed by periods of strong economic growth it can lead to increased demand and higher rents. This ultimately increases the value of the underlying properties. Over the six rising rate periods with historical returns, the Dow Jones U.S. REIT Index averaged returns of 27.2% with positive returns in four of the six periods.

MLPs & pipelines

Similar to REITs and other high yielding equities, MLPs may initially sell off with a sharp increase in interest rates as existing yields begin to look less attractive. But in an environment with steadily increasing rates  and strong economic growth, MLPs can often experience steady and growing distributions. In the rising rate periods we evaluated, the Alerian MLP Infrastructure Index was positive in four out of five periods,  with average returns of 54.9%.

When faced with the potential of sustained rising interest rates, some investors may feel the need to make significant changes to their portfolios. Rather than trying to accurately determine the fate and direction of economic cycles and markets, we prefer to focus on what we can control, building diversified portfolios focused on the long term. The best approach is to maintain exposure to investments that do well in a variety of economic environments and rebalance portfolios to policy targets to improve the odds of meeting long-term return objectives.

Steven Fraley, CFA, MBA, is Vice President at Innovest.