When Lehman Brothers filed for bankruptcy on September 15, 2008, defining the seminal event of the financial crisis, there was one big risk investors were worried about across their portfolios: credit risk – the potential losses arising from the inability of mortgage borrowers, financial institutions, and government enterprises to pay back their debts. As we reach the five-year anniversary of that event this coming weekend, another single big risk has emerged in the minds of investors: interest rate risk – the potential losses from rising interest rates on financial assets. While not worthy of anywhere near the same degree of concern as five years ago for most investors, all market participants have been focusing on this traditionally bond-market-centric risk.
Of course, for bond investors, rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. In general, the prices of longer-term and lower-yielding bonds have the greatest interest-rate sensitivity. Over the past four months, the sharp rise in the yield on the 10-year Treasury from 1.6% on May 2 to 3.0% on Friday of last week has resulted in losses for many high-quality bonds. But it has been no picnic for other asset classes either. For much of the past five years, high-yield bonds have acted a lot more like stocks than bonds, measured by statistical correlation. However, the rise in rates this year has reminded high yield bondholders that they are still bonds, as they have tracked the losses in bonds since May 2 rather than the gains in stocks.
Normally, rising rates are not a problem for stocks until the yield on the 10-year Treasury gets above 5%, when increasing inflation typically starts to become a problem. But the pace at which yields head higher matters at any level. The sharp rise in rates in August prompted a pullback in stocks. For the first time in six years, the correlation between the S&P 500 and the yield on the 10-year Treasury has turned negative.
So it seems just about everything in portfolios suddenly got very averse to rising interest rates. There is no way to completely insulate a portfolio from rising rates using traditional investments. Even holding only cash will eventually lose ground to inflation as rates rise (and current money market yields are well below the pace of inflation). So how do you provide some insulation from rising rates in your portfolio? In general, within portfolios, consider:
- Stocks over bonds
- High-yield bonds
- Low-yield stocks.
While it may be impractical or undesirable to eliminate all bond exposure from your portfolio, favoring stocks over bonds can help to mitigate interest rate risk. While stocks can suffer as rates spike, high-quality bonds may fare worse. For example, high-quality bonds, as measured by the Barclays Capital U.S. Aggregate Bond Index, are down 4.6% since May 2 while stocks are actually up 4.5%, as measured by the S&P 500 Index.
Within the bond market, high-yield bonds offer some insulation from rising interest rates relative to low-yielding bonds. However, that is not the case for stocks, where stocks with the highest dividend yields have been the worst performers. The high-yielding utilities and telecommunications sectors have fallen about 10% since yields began to rise on May 2, 2013. Lower-yielding, higher-growth sectors, such as consumer discretionary and industrials, have fared the best.
The financial sector has been among the best performers since May 2, but it has suffered over the past month as the rise in rates accelerated towards 3%. Rising rates help improve bank’s profitability as loan rates go up, but too sudden an increase in rates may hurt their assets. The impact on profitability takes place relatively slowly, as new loans are made and old loans reprice at new interest rates over time. However, as rates rise, banks immediately suffer the risk of potential losses to the market value of the bonds and other assets they hold, just like any investor.
For the overall stock market, just like for financials, a slow and steady increase in rates is generally a plus, and a sharp jump acts as a negative. Fortunately, the sharp rise in rates may be due for a pause. Historically, the yield on the 10-year Treasury tracks nominal gross domestic product (GDP) growth, or real GDP growth plus the pace of inflation (please see our June 19, 2013 Bond Market Perspectives for more on this relationship). Third quarter real GDP is tracking to 1.5 – 2% while inflation is running at 1 – 1.5%. So, last week’s rise in yields to around 3% places it right in the middle of the range of the “normal” level for the 10-year Treasury, despite the effects of the Federal Reserve’s soon to be wound down bond buying program.
No doubt, if interest rates slow – or even reverse – their recent steep climb, investors will still have plenty of other risks to turn their focus to: potential military action in Syria, sluggish global economic growth, Congress’ fiscal fight over the debt ceiling and funding for the federal government, among others. But any easing in the one big risk on investors’ minds right now would likely be a plus.