Navigating rising rates
by Zach Pandl, Senior Interest Rate Strategist
Gene Tannuzzo, Senior Portfolio Manager
Long-term interest rates have declined for roughly 30 years but are bounded at
zero. It is therefore natural to conclude that, at some point, the trend decline in
rates will end and yields will revert back to a higher level. If something can’t go
on forever, it won’t (Exhibit 1).
Exhibit 1: A 30-year secular decline in rates
20
15
10
Jan 13
Jan 10
Jan 05
0
Jan 00
5
Jan 95
> Positioning your bond portfolio
Interest rate outlook
Jan 90
> True interest rate risk differs
across bond market sectors
— and duration can be an
imperfect guide
Jan 85
> Remember that you
own duration primarily
for diversification
Jan 80
> At some point rates will rise,
but look for a gradual increase
Since the start of 2013, we have been recommending that investors start
thinking seriously about interest rate risk in portfolios. Over the last three
decades, long-term government bonds rewarded investors with healthy
real returns, relatively low volatility and good performance during economic
downturns. But at current yield levels, it is hard to escape the conclusion that
prospective returns look much worse than the solid performance of recent
history. In this article, we discuss the outlook for interest rates in detail as well
as the implications for investors’ portfolios.
10-year U.S. Treasury yield (%)
Highlights
Source: Federal Reserve, January 2013
Past performance does not guarantee future results.
We share the view that rising rates are likely to be a meaningful headwind to
high-quality fixed-income returns for the next few years. The U.S. recovery is on
more stable footing, and the Federal Reserve (the Fed) looks to be gradually
turning its attention away from pushing rates down and toward managing the
monetary exit process. As a result, rates should have a tendency to rise.
However, because of structural changes in the economy, we think the increase
will remain modest by historical standards.
NAVIGATING RISING RATES
First, and most importantly, long-term inflation expectations remain low and
stable. When asked in the late 1970s and early 1980s for their longer term
inflation outlook, both households and economists responded with estimates
around 8% (Exhibit 2). Today, longer term inflation expectations are roughly
2%–3%, depending on the survey, and they show very little volatility despite large
swings in actual inflation.
10
Households
Mar 12
Mar 09
Mar 06
Mar 03
Mar 00
Mar 97
Mar 94
Mar 91
Mar 88
Mar 85
0
Mar 82
5
Mar 79
Long-term inflation expectations (%)
Exhibit 2: Inflation expectations are now low and stable (Mar 1979–Mar 2013)
Economic forecasters
Sources: University of Michigan and Federal Reserve Bank of Philadelphia, March 2013
Note: Five-year outlook for households; 10-year outlook for economists.
More than anything else, this anchoring of inflation expectations underpins the
low interest rate environment across developed-market economies. Low and
stable inflation means lower compensation for the erosion of purchasing power
and a lower risk premium because of reduced inflation uncertainty. Success in
keeping inflation low over the last 15 years does not guarantee it will remain
that way — past performance is not necessarily indicative of future results. But
it does emphasize that a return to 1980s-like interest rates probably requires
1980s-like inflation expectations — including a breakdown of inflation-targeting
and other institutional changes at the Fed.
Second, monetary policy transparency reduces the odds of big interest rate
surprises. The very first time the Fed released a statement after an FOMC
meeting was in February 1994 — and even then it did not provide a specific
number for the size of the rate hike. Because officials provided virtually no
guidance to markets in advance, each Fed action had much bigger implications
for the bond market. Today the Fed is setting its funds rate policy with explicit
reference to economic indicators — a 6.5% unemployment rate. There is still
uncertainty about some of the details, but in general this systematic, rule-like
behavior significantly lowers the uncertainty around future monetary policy.
Third, long-term interest rates today are not entirely free-floating. Instead, we see
similarities to partially managed exchange rates: rates are market determined to
a point, but they are also affected by direct government intervention and at least
implicit policy goals. In the exchange rate world, economists often refer to this
gray area as “dirty float.”1 Under this type of regime, Fed officials would probably
tolerate a moderate glide path higher in rates but might intervene to prevent
disorderly outcomes.
Duration for diversification
We often hear investors say something like the following:
“I own stocks for growth and bonds for income.” But in
practice, of course, that is not how it really works. Investors
hold portfolios for total return but invest across asset
classes for diversification. Diversification is still one of
the most fascinating ideas of financial economics: one
portfolio can have the same risk but higher total return
than another simply by investing in different markets.
This basic principle should guide decisions about an issue
many investors are struggling with today: the appropriate
amount of bond duration in an environment of rising
interest rates. For bonds themselves, the implications of
rising interest rates are straightforward: higher rates reduce
prices and erode total returns.2 But what do rising rates
mean in a portfolio context? What is the right amount of
duration in a world with lower expected bond returns?
The answer, it turns out, relates to diversification. Since
1992, longer term Treasury securities (7- to 10-year
maturity) have delivered an annualized total return of 7.2%
(Barclays). Because of rising rates, we expect total returns
for longer term Treasuries to fall to around zero for the next
1–2 years. You can think of this as a downward shift in the
distribution of returns — instead of a midpoint of 7.2%,
the midpoint falls to zero (Exhibit 3). But the critical point
to remember is that, in this example, only the midpoint
is changing. Other aspects of Treasury returns — like
their volatility and, most importantly, their correlations
with other asset returns — need not change just because
rates are rising. This means that Treasuries can still have
diversification value — they can enhance portfolios’ riskadjusted returns — even as rates rise.
Exhibit 3: Rising rates mean a downward shift in the
distribution of Treasury returns (data since 1992–2012)
0.12
0.10
Probability
Many investors remain concerned about a 1994-like sell-off
in the bond market. However, we believe this experience
is less relevant today because of low and stable inflation
expectations, monetary policy transparency and the Fed’s
active intervention in the bond market. While we expect
interest rates to rise, our best guess is that the pace of
increase will remain gradual.
0.08
0.06
0.04
0.02
0.00
-5.0 -2.5
0.0 2.5 5.0 7.5 10.0 12.5 15.0
Annualized returns (%)
Historical
Expected
Source: Columbia Management Investment Advisers, LLC
Past performance does not guarantee future results.
It is not possible to invest in an index. Shown for illustrative purposes only
Consider a simple example in which an investor can
only purchase two assets: an S&P 500 Index and
Treasuries with 7–10 years remaining maturity. What is
the combination of these two assets that maximizes riskadjusted returns? Basic portfolio theory tells us that we
need to look at the distributions of the two assets — their
returns, volatilities and correlation. Since 1992 (shown in
Exhibit 4), we would have maximized risk-adjusted returns
by investing 21% of the portfolio in the S&P 500 Index and
79% of the portfolio in Treasuries. The portfolio would have
had an annualized return of 7.5% and volatility of 5.4% —
lower volatility than Treasuries with higher returns. Today
a portfolio like this would have a duration of 6.2 years
(calculated as the 79% Treasury share times its 7.78 year
duration).
Exhibit 4: Risk-adjusted returns depend on entire distribution
Historical returns, 1992–Feb 2013
Return
Volatility
Correlation
S&P 500 Index
8.6
14.8
-0.16
7–10 year USTs
0.0
6.3
Sources: Barclays and Columbia Management Investment Advisers, LLC
When interest rates are likely to rise and the distribution of
expected Treasury returns shifts lower (as shown in Exhibit
3), the share of Treasuries in the portfolio should decline.
But interestingly, even as expected returns fall to zero, an
optimized portfolio would still hold some Treasuries. For
example, if we think that Treasury returns will be zero, but
NAVIGATING RISING RATES
their volatility and correlation with equity returns will stay
the same, then the portfolio with the best risk-adjusted
returns would invest 73% in the S&P 500 Index and 27%
in Treasuries. This portfolio would have a duration of 2.1
years. In other words, investors maximizing risk-adjusted
returns still benefit from duration even if Treasuries
themselves return zero.
More generally, we can show that the optimal duration of
any portfolio will depend primarily on two factors: (1) the
correlation between Treasury returns and the rest of the
portfolio and (2) the difference in total returns between
Treasuries and the rest of the portfolio. These two factors
could be considered measures of the benefits and costs of
diversification, respectively.
Exhibit 5 graphs optimal durations for a portfolio of
Treasuries and equities, where the other values are set to
those in the previous example. When expected Treasury
returns fall, the optimal portfolio duration also falls. However,
when correlations, between Treasury and equity returns
decline (become more negative), the optimal duration rises.
At very low correlations, expected Treasury returns matter
very little (the lines are clustered closely together) because
the benefits from diversification easily outweigh the costs.
This means that it can be worth investing in Treasuries even
if expected returns are negative — just like the insurance on
your house, it can be worth paying up for things that pay off
at the right time.
Optimal portfolio duration, years
Exhibit 5: Optimal duration depends on expected returns
and correlations
6
Therefore, the right amount of duration cannot be
determined on a standalone basis. It has to be considered
in a portfolio context, because the main value of duration
exposure comes through diversification. With yields likely
to rise, the cost of that diversification has increased3 and
portfolio duration should fall. However, because of the
negative correlation between duration and the returns
of riskier assets, high-quality fixed income will still be a
cornerstone of any disciplined portfolio.
Measuring interest rate risk
Whatever investors’ interest rate outlook, they must
ultimately turn to the practical issue of how to manage
interest rate exposure in their portfolios. This typically
means a greater focus on duration — the most common
measure of interest rate risk in fixed income. Unfortunately,
duration can be a highly misleading measure of interest
rate risk when making comparisons across products.
Ironically, the best example of the pitfalls of duration might
be equities. Technically speaking, the duration of a stock
is equal to one divided by its dividend yield. Therefore, a
stock with a dividend yield of 2% will have a duration of 50
— even longer than the 30-year Treasury bond.
But no investor realistically believes that equities
have more interest rate risk than Treasury bonds. The
discrepancy relates to the definition of duration: it
assumes that other market factors remain constant.
In practice, however, when interest rates change, other
determinants of equity prices — like the expected growth
rate of dividends — often change too.
As a result, when comparing interest rate risk across fixedincome sectors, we prefer to use measures of “empirical”
duration. The conventional measure of duration — which
we will refer to as “analytical duration” in the discussion
below — is grounded in the bond math of cash flows and
discount rates. In contrast, empirical duration is based on
the statistical relationship between benchmark interest
rates and bond returns. It helps answer the practical
question of what returns to expect if interest rates rise.
5
4
3
2
1
0
-0.9 -0.8 -0.7 -0.6 -0.5 -0.4 -0.3 -0.2 -0.1 0.0
Correlation between S&P 500 and Treasury returns
+1%
0%
-1%
Source: Columbia Management Investment Advisers, LLC, March 2013
Past performance does not guarantee future results.
Exhibit 6 compares the average analytical duration of bond
market sectors over the last 10 years to our estimate
of their empirical duration.4 For empirical duration, the
estimates are based on each sector’s price sensitivity
to changes in the 10-year Treasury yield. By design, the
empirical duration of 10-year Treasuries is nearly identical
to the average analytical duration: if the 10-year Treasury
rises by 100 basis points (bps), prices should be expected
to fall by just over 8%, regardless of the measure we use.5
However, for all the other sectors the differences are quite significant. For
example, investment-grade corporate bonds have an average analytical duration
of over six years, but the actual sensitivity to changes in Treasury yields over the
past decade has only been about half of that. High-yield corporate bonds and
bank loans actually have negative empirical durations, meaning that they have
historically posted higher returns during periods of rising Treasury yields.
Exhibit 6: Interest rate sensitivity differs across sectors (Jan 2003–Dec 2012)
10
Duration (years)
8.3 8.2
6.2
5
6.3
6.1
3.4
2.3
3.0
4.4
4.2
2.2
2.1
1.3
0.3
0
-2.4
-5
10-year
Treasury
Investmentgrade
corporate
Emerging
market
bonds
Mortgagebacked
securities
Foreign
developed
markets
Average analytical duration
CMBS
High-yield Bank loans
corporate
Empirical Treasury duration
Sources: Barclays, Credit Suisse and Columbia Management investment Advisers, LLC, December 2012
Past performance does not guarantee future results.
As a general rule, true interest rate sensitivity tends to fall — the gap between
analytical and empirical duration widens — as we move down the credit quality
spectrum. For lower quality bonds, the impact of changes in credit spreads dwarfs
the impact of changes in benchmark interest rates. The very low or negative
empirical durations highlight that investors are not primarily taking interest rate
risk when allocating to these sectors — credit risk matters much more.
Positioning your bond portfolio
Given the prospect for rising rates, bond investing becomes a delicate exercise.
While all bonds will not react the same way to rising Treasury yields, choosing
between bonds of different maturities and sectors can have meaningful impact on
prospective returns. As a result, it can be informative to see how different areas of
the bond market have performed when Treasury rates have risen in the past.
Despite the secular decline in yields, we found 44 12-month periods in which
10-year Treasury yields rose by at least one half of a percent over the past 20
years. These examples provide some context for fixed-income performance
during periods of rising rates.
Start with government bonds. Investors may be surprised to learn that in these
periods of rising yields, the typical return on the broad Barclays U.S. Treasury Index
was actually positive, posting a median return of 0.28%. This small but surprising gain
comes from the combination of a median price loss of 5.14% and a median coupon
return of 5.42% — the coupon income modestly exceeded the capital losses.
-3.3
—
-4.2
S&P 500
Index
NAVIGATING RISING RATES
Today, however, there is much less coupon cushion to
absorb price losses if rates rise. If, for example, Treasury
yields were to rise in line with historical experience, a
5.14% price drop would dwarf the 0.89% income and lead
to a total return loss of 4.25% over a year. It’s a basic but
important fact: with low coupon income, duration matters
more for total returns. Exhibit 7 illustrates this point
across the yield curve. Historically, increases in rates have
delivered price losses to any bonds greater than three
months, and investors owning bonds with maturities five
years or longer experienced negative total returns.
In Exhibit 8, we illustrate these historical returns across
sectors. While all sectors posted a positive median total
return, most sectors did experience price losses in the
mid-single digit range. However, there are some examples
of sectors that have experienced price gains even while
Treasury yields rose. Emerging market debt stands out as
a strong performer in these environments as sovereign
fundamentals in developing economies are less dependent
on U.S. rates. Floating rate bank loans have also seen
modest price gains, as interest in the asset class has
tended to increase as investors flee longer duration assets
in rising rate periods.
Exhibit 7: Rate rise impact on Treasury curve
Conclusion
Median returns across the Treasury curve in periods
when rates have risen (1992–2012)
Returns (%)
5 4.12
History demonstrates that bond market performance
can have tremendous variance when yields begin to rise.
Duration is a significant driver of return, given the price
sensitivity of long maturity, fixed-rate issues. In addition,
sector exposure matters, as idiosyncratic factors can
cause performance of different parts of the bond market
to diverge. Lastly, fundamental research can help investors
avoid potholes. For example, it may seem that emerging
market bonds are the best defense to rising Treasury
rates, generating a median return of 14.6% during these
historical periods. Keep in mind, however, that 14.6% is
the median return, within a range of -19.8% to 37.7%.
Therefore, investors should keep a diversified approach,
focusing on bonds that offer enough yield (or risk premium)
to compensate for potential price volatility.
2.08
0
-5
-0.38
-3.36
-10
-15
-6.19
3-month
2-year
Income return
5-year
10-year
Price return
30-year
Total return
Sources: Barclays and Columbia Management Investment Advisers, LLC
Measures median 12-month return during 44 periods over the past 20 years
in which 10-year Treasury yields rose by at least 0.50% over 12-month period.
Past performance does not guarantee future results.
Exhibit 8: Rate rise impact on bond sectors
Median returns across sectors in periods when rates have risen (1992–2012)
15
14.64
13.57
Returns (%)
10
7.59
5.10
5
4.59
4.32
2.58
2.04
1.89
1.12
0.32
0.28
0
-5
-10
Emerging S&P 500
market
Index
bonds
Bank
loans
HighForeign
Multi1-5yr IG Mortgage- Municipal
U.S. Investment- U.S.
yield
developed sector corporate backed
bond
aggregate grade
Treasury
corporate markets benchmark*
securities
corporate
Income return
Price return
Total return
Sources: Barclays, Merrill Lynch, JP Morgan, Credit Suisse, S&P, Columbia Management Investment Advisers, LLC
Measures median 12-month return during 44 periods over the past 20 years in which 10-year Treasury yields rose by at least 0.50% over 12-month period.
*Multi-sector benchmark = 35% U.S. Aggregate, 35% U.S. High Yield, 15% Emerging Market Bond, 15% Foreign Developed Market Bond
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NAVIGATING RISING RATES
References
1
“‘Dirty Float’ in the Bond Market.” Columbia Management Perspectives,
March 25, 2013.
2
With the caveat that benchmark interest rates and credit spreads often
move in opposite directions, which will dull the impact of rising Treasury
yields on corporate bonds and other spread sectors.
3
That being said, the benefits have arguably increased, too: in recent
years Treasury returns have been more negatively correlated with risky
assets than in the past.
4
Empirical duration estimates shown here are based on historical data
and derived from regressions. It is also possible to develop forwardlooking estimates of empirical duration, but that is beyond the scope of
this article.
5
We ignore convexity throughout this discussion.
The views expressed are as of the date given, may change as market or
other conditions change, and may differ from views expressed by other
Columbia Management Investment Advisers, LLC (CMIA) associates or
affiliates. Actual investments or investment decisions made by CMIA and
its affiliates, whether for its own account or on behalf of clients, will not
necessarily reflect the views expressed. This information is not intended
to provide investment advice and does not account for individual investor
circumstances. Investment decisions should always be made based on an
investor’s specific financial needs, objectives, goals, time horizon and risk
tolerance. Asset classes described may not be suitable for all investors.
Past performance does not guarantee future results and no forecast
should be considered a guarantee either. Since economic and market
conditions change frequently, there can be no assurance that the trends
described here will continue or that the forecasts are accurate.
Risks include prepayments, foreign, political and economic developments
and bond market fluctuations due to changes in interest rates. When
interest rates go up, bond prices typically drop and vice versa. Lower
quality debt securities involve greater risk of default or price volatility from
changes in credit quality of individual issuers.
It is not possible to invest directly in any of the unmanaged indices
listed below.
The Barclays U.S. Treasury Index includes public obligations of the U.S.
Treasury that have remaining maturities of more than one year.
The Standard & Poor’s 500 Index (S&P 500 Index) is an unmanaged list of
common stocks that includes 500 large companies.
The Barclays U.S. Aggregate Index is an index comprising approximately
6,000 publicly traded bonds, including U.S. government, mortgage-backed,
corporate and Yankee bonds with an average maturity of approximately 10
years. The index is weighted by the market value of the bonds included
in the index. This index represents asset types that are subject to risk,
including loss of principal.
Diversification does not assure a profit or protect against loss.
Duration — A measure of the sensitivity of the price of a fixed-income
investment to a change in interest rates.
Correlation — In finance, a statistical measure of how two securities move
in relation to each other.
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