Investing in a Rising Rate Environment

Fixed Income

Bonds are typically hit the hardest during periods of rising interest rates, as their fixed payments become less attractive relative to new issues, resulting in a decline in price. Investors should focus on the overall duration (sensitivity to interest rates) of their bond portfolio since longer term maturity bonds are impacted the most. Shorter maturity bonds on the other hand are less impacted and help reduce the portfolio's sensitivity to interest rates. The average returns of the Bloomberg Barclays Govt/Credit 1-3 Yr  Index, Bloomberg Barclays Agg Index (duration of ~6 years), and the Bloomberg Barclays Us Gov/Credit  Long Index (duration of ~13 years), were 3.9%, 2.2%, and -2.1%, respectively.

Floating rate corporate loans

To reduce the overall sensitivity to changes in interest rates within a bond portfolio it might make sense to consider an allocation to floating rate corporate loans. Compared to traditional fixed rate bonds, their coupon rate adjusts or "floats" with the market rate, providing investors with additional yield when  interest rates rise. The average return of the S&P/LSTA Leveraged Loan Index over the five periods of  available data was 22.7%. More impressively, there were no negative returning periods.

Equities

Contrary to what some believe, stocks typically perform well during periods of rising interest rates. While rising rates can create some uncertainty and headwinds as companies decide how to borrow and invest  capital, it typically coincides with stronger economic growth. The average return of the S&P 500 Index during the periods we looked at was 32.9%, with no negative time frames. Returns were even better outside of the U.S. with the MSCI ACWI ex USA Index returning 42.3% on average over six periods.

U.S. REITs

On the surface it might seem that rising interest rates are bad for Real Estate Investment Trusts (REITs),  since an increase in rates leads to higher borrowing costs. While this can be true in the short-term, if a rise in rates is followed by periods of strong economic growth it can lead to increased demand and higher rents. This ultimately increases the value of the underlying properties. Over the six rising rate periods with historical returns, the Dow Jones U.S. REIT Index averaged returns of 27.2% with positive returns in four of the six periods.

MLPs & pipelines

Similar to REITs and other high yielding equities, MLPs may initially sell off with a sharp increase in interest rates as existing yields begin to look less attractive. But in an environment with steadily increasing rates  and strong economic growth, MLPs can often experience steady and growing distributions. In the rising rate periods we evaluated, the Alerian MLP Infrastructure Index was positive in four out of five periods,  with average returns of 54.9%.

When faced with the potential of sustained rising interest rates, some investors may feel the need to make significant changes to their portfolios. Rather than trying to accurately determine the fate and direction of economic cycles and markets, we prefer to focus on what we can control, building diversified portfolios focused on the long term. The best approach is to maintain exposure to investments that do well in a variety of economic environments and rebalance portfolios to policy targets to improve the odds of meeting long-term return objectives.

Steven Fraley, CFA, MBA, is vice president at Innovest.