Background: It has now been more than 10 years since the Federal Reserve has increased their target on the Federal Funds (FF) rate. The effective FF rate is the interest rate at which depository institutions lend balances to each other overnight. This impacts the amount of money banks will loan out to consumers and businesses. Further, this impacts the rate you pay on mortgages, and the interest earned on savings and checking accounts. As the FF rate remains low, more people will look to purchase a home and more businesses will look to borrow money to fund growth. Conversely, if the Federal Reserve feels growth is healthy and we are at risk of above target inflation, they will increase the FF rate target to slow down lending and growth. Therefore, the Federal Open Market Committee (FOMC) must observe the current state of the economy to determine the best course of monetary policy that will maximize economic growth while adhering to the dual mandate set forth by Congress. Below, we can see the effective FF rate from 1954 to present. The most recent data point for the effective FF rate was 0.12%. Whereas the average during the time period is slightly above 5.00%. As such, a normalization in rates would indicate a significant increase in the target set by the FOMC. In the last round of increases, from June of 2004 to June of 2006, the rate target went from 1.00% to 5.25%. Here, we experienced +0.25% rate hikes at each of the eight FOMC meetings throughout the year.
How have stocks reacted in a rising rate environment?
In an article from Morningstar (Peters, J. 2013, December 12. What to Expect When Interest Rates Rise. Morningstar.), Mr. Peters noted seven rising-rate cycles (a move of 1% or more) since 1992 and on average lasted 9.3 months. The average total return for the S&P 500 during these rising-rate environments has been 11.0%. He further noted that the S&P 500 recorded a positive total return in all seven periods. In contrast, high dividend yielding stocks did not fare as well. This makes theoretical sense as an investor may purchase a high dividend stock more for the income stream rather than the growth prospects. In this regard, as interest rates rise, unless the dividend is keeping pace with rates, an investor may sell the position to purchase a higher paying position. Below is the data from Morningstar for each rising-rate period from the article.
(Data Source: Peters, J. 2013, December 12. What to Expect When Interest Rates Rise. Morningstar.)
In a white paper from Russell Investments, the authors further expanded the time frame of analysis back to 1970. Their findings showed a slight underperformance for U.S. equities during periods of rising rates (9.7% annual return) versus (10.7%) periods of falling rates. (Madden, W. and Totten, S. 2014, January. When rates rise, do stocks fall? Russell Research.) In addition, they noted that U.S. equities perform best in times when rates rise slowly and gradually. Finally, they concluded that the U.S. underperformed their international counterparts in 9 of 11 rising rate periods.
How have bonds reacted in a rising rate environment?
In general, as interest rates rise the price of a bond will decrease. In a roundtable discussion from the Journal of Financial Planning, (Kitces, M. 2014, June. Investing for Rising Rates. Journal of Financial Planning.), participant Brent Burns notes two contrasting periods of interest rates. Interest rates rose from the 1950s to peaking in 1981. Since then, there has been a secular decline to where they are today. In the period from 1950 to 1981 on the 10-year Treasury index, the annualized total return (price changes plus interest payments) was 2.2%, whereas if you go from 1981 to 2013, it’s about 10.9%. This is a drastic difference; especially for investors with large allocations to fixed income and for those that depend on their portfolio for living expenses. Historically, the total return of bonds have been driven mostly by the income or coupon payments rather than changes in the price of the bond. As such, concern should focus on a lower total return environment and if you are able to still meet your objectives. Although you are receiving interest payment from bonds you own in your portfolio, the price of the bond may decline in a rising rate environment. As an example, in 1999, the Barclays U.S. Aggregate Bond Index paid interest of 6.7%. However, the price of the index declined -7.0%. As such, the total return for the year was -0.8%.
For investors hoping that an actively managed bond fund will outperform during periods of rising rates, you may want to revisit your strategy or closely monitor the manager’s performance. In a white-paper from Vanguard (Phillips, C. and Walker, David. 2011, August. Rising rates: A case for active bond investing? Vanguard Research.), the authors concluded that during rising rate periods in the 30-years ending 2011 the average actively managed bond fund underperformed its benchmark.
There are sectors of the bond market that may react differently than traditional bonds during times of rising rates. One characteristic of a bond that influences the price sensitivity to interest rates is how the coupon payment is calculated. The following are a few examples of non-traditional coupon paying bonds. A step-up bond is a security in which the coupon increases or “steps”, according to a preset schedule. The initial coupon is typically lower than that of a fixed rate bond, but as it approaches maturity and assuming it isn’t redeemed by the issuer, the interest income will increase over time. Treasury Inflation Protected Securities (TIPS) are designed to preserve purchasing power during inflationary periods. The bond’s value is adjusted semiannually based on changes in the Consumer Price Index of Urban Consumers. Bank loans are fixed income securities from below-investment grade issuers in which the interest payment is adjusted every 30-90 days. As such, as rates rise, the income received will be adjusted accordingly.
Other Asset Classes
Real Estate: Lazard Asset Management noted that Real Estate Investment Trusts are initially likely to react similar to bonds for the following reasons; they pay relatively high dividends, are partially priced based on their yields, and they have generated about two thirds of their total return from dividend distributions. (Lazard Research. 2014, March. Real Estate in a rising rate environment.) However, if interest rates are rising due to an improving economy, commercial real estate values are likely to strengthen as a result of higher rents and occupancy, more liquid capital markets, and narrower debt spreads. In an article in Investment News, they cite that within the real estate space, the sectors with the shortest leases have the biggest pricing power advantage. Hotels, as an example, can adjust prices throughout the day and are best positioned to adjust to rising rates. In contrast, some nursing home facilities may have leases that are secured for 20 years or more. (Benjamin, J. 2015, Mar. Rising interest rates to test REIT strength even as investors seek diversification. Investment News.) It is noted that there is limited experience in constructing real estate price indices as markets are heterogeneous, both within and across countries.
Gold: Below is a graph of monthly values for the price of gold (blue line with scale on the left) and the effective FF rate on the right. The historical values suggest a moderate negative correlation between the price of gold and the effective FF rate, a reading of -0.51. However, if rising interest rates do not keep pace with inflation, gold may see some price relief.
Interest rates have experienced two distinct periods since 1950; rising rates from 1950 to 1981, and falling rates from 1981 to present. The impact on various assets classes differ. Significantly impacted, traditional fixed income bonds posted very different total return profiles in the interest rate periods. Whereas stock investments were less impacted by a rising rate versus a falling rate environment. For real estate, performance is impacted by many factors in addition to the nominal direction of interest rates, and performance has been challenging to track given the nuances of various markets and illiquid prices. For gold, although negatively correlated to the effective federal funds rate, is also positively correlated to inflation.
It is very difficult to predict the timing and magnitude of interest rates. However, planning for various scenarios and the impact on portfolio positions is prudent. As the well-known quote goes, “The time to repair the roof is when the sun is shining.”
Cory Michael Nakamura CFA, CFP®
Chief Investment Strategist and Financial Advisor
CERTIFIED FINANCIAL PLANNER™ professional
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