Managing Your Portfolio’s Exposure to Interest Rates

Today, the yields on ten-year Treasury bonds are at a fifty-year low, and no period prior to the last few years reflects yields that even come close.  From 1962 to 2005, the lowest the 10-year Treasury bond yield ever got to was just below 4%, more than twice the current yield.

The chart below shows how unusual our current environment is.  The vertical axis is the yield from 10-year Treasury Bonds and the horizontal axis is time and we are looking at a period from 1962 to present.  From 1980 to today, we have seen the yield of 10-year Treasury bonds go from about 12% per year to below 2%.  The 10-year Treasury yield is considered a benchmark measure of bond yield and interest rates.  The Fed funds rate and the 10-year bond yield are very closely tied to one another.  For another illustration of how interest rates, the Fed funds rate and 10-year bond yield are related, see here.

CBOE 10-Year Treasury bond Yield (Source: Yahoo! Finance)

There is limited potential for further declines in bond yield and interest rates, but there is considerable potential for a rise in both.  There has to be some ultimate floor on Treasury yield, below which investors will not be willing to lend the U.S. government money by buying bonds.  We do not know what that floor is, but it seems obvious that this floor must exist and that there is a great deal more room for yields to rise than to fall further.  Current 10-year yields are below the rate of inflation (as measured by the CPI), for example, which means that investors in 10-year Treasury bonds are actually paying to lend money to the U.S. government.  The interest and repayment of principle on the bonds will be made with inflated future dollars, so the after-inflation rate of return is less than zero.

For retirement savers, Treasury bond yields are tremendously important, showing how much income investors can reap without risking their capital, because U.S. Treasury bonds are considered to have no default risk.

There is another reason that the trailing 30-year period of falling bond yields is important.  Some asset classes will tend to generate higher returns in periods of rising bond yields and some asset classes will tend to generate lower returns in response to rising bond yields.  Treasury bond prices will tend to fall as yields increase and stocks tend to increase in price as bond yields increase.  This is one of the major reasons why combining stocks and bonds in a portfolio provides diversification benefit.  What investors in the current market should be very concerned about is how their portfolios are correlated to changes in bond yields.  Many portfolios that have delivered attractive returns over this 30-year period of falling rates may be decidedly less attractive when rates rise.

Different people have their beliefs on where interest rates and bond yields are going.  If we start to see substantial inflation or if the Fed progressively phases out its program of Quantitative Easing (QE), we will see yields rise.  If the U.S. continues to slow economically and ends up with a long-term malaise, similar to that experienced in Japan, we could see interest rates fall further.  Let’s imagine for a moment that you don’t want to bet on which way bond yields are going.  What assets will be more attractive if your goal is to be neutral with regard to changes in bond yield and interest rates?

The chart below shows a novel way to look for asset classes that are fairly neutral with regard to bond yields, while controlling your exposure to market risk.  While Treasury bond returns are negatively-correlated to bond yield, stock returns tend to be positively correlated to bond yield.  The S&P 500, for example, has a modest positive correlation to 10-year Treasury yield.  Investors need to also consider their exposure to market risk, however, and that can be tracked using Beta, which measures the degree to which an asset class goes up or down with the market (e.g. the S&P 500).  If Beta is greater than 100%, an asset class tends to go up more than 1% for a 1% gain in the S&P 500 (and vice versa).  We might say that an asset class with Beta greater than 100% tends to amplify moves in the S&P 500 and that an asset class with Beta less than 100% tends to have a muted response to moves in the S&P 500.  While reducing your exposure to changes in bond yield (e.g. reducing your interest rate risk) by taking on more market risk may be a reasonable solution for some people, I want to look for asset classes that have low interest rate sensitivity and fairly low market risk.

The asset classes on the right side of this chart tend to benefit from rising Treasury yields and the asset classes on the left side tend to benefit from falling yields.  What are the asset classes that are fairly insensitive (have modest correlations) to bond yields as well as having fairly low Beta?  The chart below provides the answer.  Utility stocks (IDU and IPU) and high-yield bonds (HYG) all fit the bill.

REITs have a modest positive correlation to ten-year yield, but a Beta over 150%. High-dividend stocks are fairly neutral with regard to bond yield, but they have substantial market risk (fairly high Beta).

Source: Author

The chart above does not mean, however, that investors should avoid asset classes with large positive or negative correlations to bond yields.  By combining different asset classes, high positive and high negative correlations to bond yields will tend to offset one another.  A portfolio that holds 50% in an S&P 500 index fund and 50% in an aggregate bond index (such as AGG) has a Beta of 51% and a 12% correlation to 10-year Treasury yield.  A 12% correlation to yield means that this simple portfolio is very close to neutral with regard to yield changes.

While it is not hard to create a portfolio that is fairly insensitive to Treasury bond yields, investors need to be wary at the extremes of asset allocation.  Investors who are exceedingly conservative and hold large allocations to Treasury bonds, for example, need to be aware that they may have lots of interest rate risk even though they have low market risk.  Investors who want a portfolio with modest market risk and low interest rate risk can achieve this with a simple diversified portfolio or by selectively allocating more of their portfolios to the asset classes that have both of these features.

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3 thoughts on “Managing Your Portfolio’s Exposure to Interest Rates

  1. Bill

    Geoff – Very thoughtful article. But I’m wondering how inflation factors into your conclusions about the effect of interest rates on asset prices. For example, if inflation is low, as it has been recently, then we see a positive correlation between interest rates and stocks, as you found. But if inflation is high or accelerating then we’d probably see a negative correlation between interest rates and stock prices, as in the 1970s, correct? The last thing you’d want is a higher stock allocation to neutralize rising interest rates in this scenario. So isn’t an “interest rate neutral” portfolio allocation significantly dependent on the inflation rate? How do you account for this in your research?

  2. Geoff Considine Post author

    Hi Bill:

    Thanks for the note. In general, interest rates and bond yields will go up in response to inflation. So, assets that do well in a rising rate environment will also tend to do well in an inflationary environment. That said, the historical relationship of asset prices to inflation is complex–see this piece by Jeremy Siegel:

    The basic idea is that real assets will tend to do okay in an inflationary environment and that stocks represent a claim on real assets. That seems less true in a post-industrial economy (e.g. stocks with high price to book value). The other idea is that stocks do okay in an inflationary environment because they can raise the prices that they charge for the goods or services that they sell. This may or may not be true. In a stagnant economy with inflation (so-called stagflation), companies probably can’t just raise prices at will. In the case of equity energy, the firms do see the prices they get rising with inflation…an oil company sells oil at the prevailing price.

  3. Pingback: Game Theory, Behavioral Finance, and Investing: Part 1 of 5 « Portfolio Investing Blog: Portfolioist

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