Rising Interest Rates and the Impact on Bond Portfolios

Larry Swedroe on why, before some dire forecast causes you to panic over risk in your bond holdings, it’s well worth recalling that the collective wisdom of the market is a very tough competitor.

As director of research for Buckingham Strategic Wealth and The BAM Alliance, one of the most-asked questions I’ve been getting lately involves bond portfolios and the impact of rising interest rates.

It’s not as if investors didn’t already have enough to worry about with U.S. equity valuations at historically very high levels (the CAPE 10 ratio is above 34 as I write this), a dysfunctional Congress (that led to a brief government shutdown) and plenty of geopolitical risks (such as North Korea and the Middle East). Now investors have to worry about rising interest rates, and the impact they could have on their bond holdings.

Among those sounding a warning was highly regarded Wharton professor Jeremy Siegel, who in late 2016 called bonds “dangerous.” On Jan. 9, 2018, the “bond king,” Bill Gross, declared a bond bear market was confirmed. Also on Jan. 9, 2018, highly regarded bond investor Jeffrey Gundlach of DoubleLine Capital warned in a conference call that if the 10-year yield reaches 2.63%, it will then accelerate higher, “spooking” equity markets. As I write this, the 10-year yield is 2.66%. Finally, on Jan. 24, 2018, hedge fund manager Ray Dalio said that the bond market has slipped into a bear phase, warning that a rise in yields could trigger the biggest crisis for fixed-income investors in nearly 40 years.

So what, if anything, should investors be doing about the rising risks in their bond portfolios?

Information Vs. Knowledge

Perhaps the most important thing to do is to not confuse knowledge with value-added information. In investing, there is a major difference between information and knowledge.

Information is a fact, data or an opinion held by someone. Knowledge, on the other hand, is information that is of value. In this case, the information is that the Federal Reserve is expected to raise interest rates three times in 2018. That leads many investors to conclude they should minimize duration risk, investing in only relatively short-term bonds. However, that’s a mistake. Here’s why …

At the core of the efficient markets theory is that new information is disseminated to the public so rapidly and completely that prices instantly adjust to new data. If this is true, an investor can consistently beat the market only with either the best of luck or with inside information (on which it is illegal to trade).

In other words, if you have information about the market, it’s virtually certain the big institutional investors setting prices also have that information and have already incorporated it into prices. And interest rate futures show the market now believes the likelihood (but not certainty) is for three federal funds rate increases in 2018. The Federal Reserve Bank of St. Louis even publishes its forecast of the federal funds rate. Clearly, the market is aware that rates are likely to rise.

We also see evidence of the market’s expectations in the current yield curve.

For example, as I write this, the one-year Treasury note yield was 1.77%, while the two-year Treasury yield was 2.06%. Let’s assume you are an investor who believes rates are rising and, thus, you should stay short. So you invest in the one-year Treasury, earning 1.77% the first year. Upon maturity, you reinvest in another one-year note.

Instead, you could have chosen to buy the two-year Treasury and earn 2.06% for two years. Had you done so, you would have earned a total return of 4.16%.

For you to come out ahead, in one year, the one-year Treasury would have to have risen to 2.39%, or a total of 62 basis points. And even if the Fed raises the federal funds rate three times (25 basis points each time), that doesn’t mean the one-year rate, or any other part of the yield curve, will also rise 75 basis points. Yield curves can flatten or steepen.

2017 provided the perfect example of why investors should ignore clarion cries from market forecasters. As in 2018, we entered 2017 with the market anticipating several increases in the federal funds rate. Recall it was in late November 2016 that Jeremy Siegel warned bonds were dangerous. And the market did get its three federal fund rate increases.

Despite that, the Vanguard Long-Term Treasury Index ETF (VGLT) returned 8.6% in 2017, outperforming the Vanguard Intermediate-Term Treasury Index ETF (VGIT), which returned 1.7% and the Vanguard Short-Term Treasury Index ETF (VGSH), which returned 0.0%. Investors scared off by the likelihood of rising rates suffered for betting against the collective wisdom of the market.

The bottom line is that the collective wisdom of the market is a very tough competitor. In addition, while you may believe you have information about the direction of interest rates, it doesn’t tell you anything about whether you can use that information to outperform. In fact, it tells you nothing, because information that everyone else possesses is of no value, at least in terms of its use in trying to outperform the market.

With all this said, there is one more important point I want to cover.

Forewarned Is Forearmed

For at least five years now, many gurus, including Jeremy Grantham and John Hussman, have been vociferously warning about the overvaluation of U.S. equities. For example, in February 2013, in his quarterly newsletter, Grantham wrote that “all global assets are once again becoming overpriced” and that some securities were “brutally overpriced.”

One explanation offered for the persistent high valuations of U.S. stocks has been that the Fed’s easy monetary policy suppressed yields. That led many investors, especially those who invest from a cash flow (versus total return) perspective, to take on more risk—bond yields were not sufficiently high to meet their spending needs. In turn, many abandoned safe bonds in favor of investments such as dividend-paying stocks and REITs. Those cash flows helped drive equity valuations higher.

Nassim Nicholas Taleb wisely observed that only lucky fools judge a strategy by the outcome without considering what alternative universe might have shown up. Cash-flow investors who left the safety of bonds to take on equity risks got lucky, as equity risks did not appear.

Of course, at some point they will. Because stocks compete with bonds, if rates rise sufficiently, those same investors could abandon dividend-paying stocks and REITs, and return to the safety of high-quality bonds. And that could have implications for those assets.

The important message is that you should not assume more equity risk than you have the ability, willingness or need to take, regardless of where interest rates are, because you never know which alternative universe will show up.

Alternative Strategies

For investors who need more return than safe bonds can provide, there are safer alternatives than either junk bonds or additional equity investment. We recommend allocations to four alternatives, each of which we believe has equitylike returns with much lower volatility.

The four alternatives we use are the AQR Style Premia Alternative Fund (QSPRX) and three funds from Stone Ridge (LENDX, SRRIX and AVRPX). We believe that an equal-weighted portfolio of these four funds has forward-looking return expectations similar to that of a global equity portfolio, but with only about one-quarter of the volatility (5% versus 20%). (Full disclosure: As noted, my firm, Buckingham Strategic Wealth, recommends AQR and Stone Ridge funds in constructing client portfolios.)

One reason the volatility of this four-alternative portfolio is that low is because of the low correlation of the funds’ returns. A second benefit of such a portfolio is that it virtually eliminates term and inflation risk.

The trade-off is in two forms: The Stone Ridge funds are interval funds (thus, you don’t have daily liquidity), and you give up the flight-to-safety benefits that a portfolio of safe bonds can provide in severe equity bear markets. On the other hand, you do have higher forward-looking return expectations and you minimize term risk. For many, that’s a good trade-off.

The alternative portfolio can also be used as a substitute for equities. In that case, the forward-looking return expectations should be similar but with much lower volatility, again only about one-quarter of that of a global equity portfolio.

I’d note that none of these four strategies is new. They have been available to institutional investors for, in some cases, decades. It’s just that they have only become available to retail investors in recent years (and without the typical 2/20 hedge fund fees), thanks to the SEC’s approval of the interval fund structure.

This commentary originally appeared January 26 on ETF.com

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