Looking for new sources of income and diversification will be crucial to dealing with the challenges of rising interest rates and inflation.

A New Environment

  • The economy is accelerating, wages are firming and the potential for renewed inflation is growing for the first time in years.
  • As a result, the Federal Reserve raised interest rates three times last year, with three or four increases possible in 2018.
  • With the tightening cycle now in full swing, investors are faced with a key question:
    How can you build or adjust portfolios to seek protection and potential gains?

Inflation Is Turning Upward

Inflation Expectations

Source: Bloomberg, through January 2018. Five-year, five-year forward inflation rate.

A New Approach

  • A rising rate environment requires not one, but multiple lines of attack.
  • Investment grade bonds are a traditional hedge for equity exposure but in rising rate environments haven’t proven as effective in this role.
  • It’s important to take steps to attempt to limit negative impacts but also seek to capitalize on today’s fundamentals.
  • This means taking some basic precautions but also expanding the universe of approaches and asset classes that might translate into returns.
  • Among their choices, investors can capitalize on strategies that provide both additional yield and diversification with little or no duration (or sensitivity to changes in interest rates).
  • Potential solutions will be found not just in fixed income, but also equities and alternative assets.

Idea 1  |  Reduce Your Duration

As most financial professionals know, shortening overall duration limits exposure to interest rate turbulence. But many core bond strategies are very close to their benchmarks, which today carry heightened duration risk. One possible approach is to reduce core bond exposure; a better one is to consider managers with the flexibility to move to shorter duration when conditions warrant. Another idea is to look to fixed income strategies that provide healthy yields in relation to their duration exposure—for example, senior secured floating rate loans or short duration high yield.

  • Floating Rate Loans are debt obligations issued by banks that consist of loans made to companies. They are “floating rate” because their interest rates adjust with short-term benchmarks such as Libor, and “senior secured” because although non-investment grade, they are high in the company capital structure. With their floating characteristic, they tend to be resilient in a rising rate environment.
  • Short Duration High Yield Strategies provide a yield advantage like their longer-dated high yield counterparts, but given their shorter maturity structure have less sensitivity to interest rate fluctuations. With what many anticipate as an extended economic cycle, credit prospects for issuers of floating rate loans and short duration high yield bonds are favorable.

Fixed Income Indexes Are More Vulnerable—and So Are Strategies that Mirror Them

Duration and Yield of the Barclays U.S. Aggregate Bond Index

Source: Barclays. As of December 31, 2017.

Floating Rate Loans and Short Duration High Yield: Appeal in Rising Rate Environment

Yield vs. Duration

Source: Barclays, S&P/LSTA, as of December 31, 2017. Yield is representative of yield to worst for bonds and yield to maturity for senior floating rate loans.

Idea 2  |  Create an Inflation Hedge

Certain asset classes and sectors tend to have a high correlation to inflation, and thus tend to stand up better to the interest rate increases that often come at the same time.

  • Treasury-Inflation Protected Securities (TIPS) can potentially provide insulation from rising prices in the form of increases to principal based on the inflation rate (and decreases with deflation). With little or no inflation in recent years, TIPS have been a fairly stagnant investment. But with inflation on the rise, TIPS now look more appealing, especially as their prices may not fully reflect inflation expectations that could get worse should trade and fiscal policy add to inflationary pressure.
  • Commodities such as oil are traditional inflation hedges, with a high correlation to inflation rates and thus a tendency to outperform in rising rate environments. Slow global growth and excess capacity in many industrial commodities led to a five-year downturn that ended early in 2016. Curbs in oil production and the steady increase of demand for a range of commodities have helped contribute to better prospects for the group.
  • Real Estate Investment Trusts tend to experience performance headwinds in anticipation of rate increases, but because they benefit from the economic growth that often accompanies Fed tightening cycles, they are generally resilient once those rate increases begin.

Rising Rates Don’t Have to Mean Weak Returns

Returns during calendar years that include more than one rise in the U.S. federal funds rate

Source: Bloomberg, Government bonds - Bloomberg Barclays U.S. Treasury Index; Emerging Markets Debt (EMD) - JP Morgan EMBI Global Diversified; Floating Rate Loans - S&P/LSTA U.S. Leveraged Loan 100 Index; High Yield - Barclays U.S. High Yield Index; MLPs - Alerian MLP Index; High Dividend Yield Equities - MSCI World High Dividend Yield Index; U.S. Equities - S&P 500; REITs - FTSE EPRA/NEREIT Index, Emerging Market Equities – MSCI EM Index; Developed Non-U.S. Equities – MSCI EAFE Index. Historical trends do not imply, forecast or guarantee future results.

  • U.S. Equities are a potential interest rate and inflation offset that investors may forget. Powered by a strong economy, many can enjoy strong results as the economy accelerates, even with the Fed raising rates. Selectivity can be important, so as to pick companies that are better able to pass along costs to their customers. Given optimism around U.S. economic growth, we believe that the asset class has room to run.
  • Non-U.S. Equities may also be valuable in dealing with the portfolio impacts of inflation. Not only can earnings gain strength in inflationary times, but valuations in established international markets are currently more reasonable than U.S. counterparts. Emerging markets, while more volatile, have generally surged during rate increases, as they particularly benefit from tailwinds associated with global growth.
  • Higher Yielding Equities (those with healthy dividends in relation to price) are often perceived as facing headwinds when rates rise due to increased competition for investors’ capital. However, they can benefit from the same economic growth trends as the larger equity universe. A key to investment success in this group is to focus on companies with pricing power and the ability to grow dividends—a cohort that has historically provided a cushion amid rising rates.

Dividend Growers Saw Success in the Last Rate Cycle

Total Return

Source: Bloomberg, Neuberger Berman. High-dividend stocks and top dividend growers include constituents of the Russell 3000 Index with at least a 2.5% dividend yield and $2 billion in market capitalization.

  • Private Equity investments have the added benefit of a long time horizon. Without having to focus on short-term performance pressures, their managers can work to make organic changes to their privately held portfolio companies, and they have more flexibility in when and how they realize gains.
  • MLPs, or publicly traded partnerships, also tend to benefit from improved economic growth, as that means increased use of hydrocarbons that power volumes in midstream assets like pipelines. Importantly, their higher yields can offer some protection from rising rates (see next section) both in terms of volatility and the yield component of their income. In recent months, the Alerian MLP Index has provided a substantial premium to its historical 340-plus yield spread over Treasuries.
  • Floating Rate Loans (Idea 1) and High Yield Debt (Idea 3) may potentially also provide some insulation from inflation, due to the former’s adjustable yields and the latter’s price exposure to economic growth.

Idea 3  |  Look for Credit-Based Yield

It’s simple math that a higher bond coupon reduces interest rate risk. But just as important, income provided by a fixed income investment can offset price declines tied to changes in rates. That’s something government debt used to be able to do, but cannot today because of its still-low yields due to years of monetary easing. In the current environment, yield must be derived from other sources such as credit and illiquidity risk.

  • High Yield Debt has historically tended to be more correlated to equities than to other fixed income, and generally has shorter duration, thus making it more buoyant in the face of rising rates. Similar to REITs, high yield fundamentals (and those of floating rate loans) benefit from strong economic growth. With improving business activity and optimism over tax reform, reduced regulation and pro-growth policies, the U.S. economic picture looks healthy, which should extend the credit cycle—a key factor in high yield valuations.
  • Emerging Markets Debt (EMD) benefits from the global economic growth that often accompanies Fed rate increases, offering appealing yields and some diversification away from U.S. bonds. However, the normalization of the yield curve can have a negative impact on EMD via weaker currency translations and more expense in servicing U.S. denominated debt.
  • Private Debt finances an array of corporate transactions including buyouts, refinancings and acquisitions, typically for middle market companies. It may include first lien loans (atop the capital structure with priority over unsecured or more junior debt), second lien loans (variable rate securities with attractive coupons) and mezzanine debt (combining contractual payments and equity upside). Yields in private debt tend to be higher than market yields for comparable credits due to extended lockup periods—what’s known as an illiquidity premium—and tend to have a variable component that protects investors as rates move upward. Private debt may be offered as a standalone or as part of a diversified private equity fund.

Idea 4  |  Add New Sources of Uncorrelated Return

Looking beyond traditional asset classes and sectors can add to investment return with relatively low vulnerability to rate increases.

  • Hedge Funds have historically performed relatively well during periods of rising rates. The increased cost of capital helps differentiate among companies, bolstering managers who can take long and short positions. Event-driven managers, who seek to capitalize on M&A and other corporate activity, also benefit as their expected returns are often tied to the risk-free rate plus a risk premium, both of which typically increase in rising rate environments. Macro-oriented managers can benefit through short fixed income positions as well as larger directional moves tied to volatility.
  • Option Writing can capitalize on the significant premium investors will pay to hedge risk on a temporary basis. “Writing” or selling a put means providing other investors with the right to sell a given stock or index on a particular date and at a particular price in exchange for a cash payment or “premium.” Collecting those premiums repeatedly in a systematic way has the potential to generate equity-like returns with return patterns that bear little relation to the rate cycle.

Option Writing Can Add to Portfolio Efficiency

Index Annual Return vs. Risk, June 2007 – December 2017

Source: CBOE and Bloomberg. Index data sourced from CBOE and Bloomberg LP and is gross of fees unless stated otherwise. Selected time period reflects the longest common history of indexes.

  • Alternative Risk Premia Strategies can offer valuable diversification in the face of interest rate risk. Investment assets often carry exposures to the same risk factors, such as value, momentum and carry. Isolating such factors has been shown to be both rewarding and highly diversifying against traditional stock, bond and inflation-sensitive investments. Asset managers typically need to use shorting and derivatives to execute such strategies, which can be complementary to other elements of a portfolio.
  • Multi-Asset Income Strategies are a way to seek to capitalize on many of the elements described above, employing a variety of alternative income sources to provide generous yields while limiting duration. Exposures may include high dividend stocks, master limited partnerships (MLPs), REITs, high yield bonds, leveraged loans and emerging markets debt. Although more volatile than traditional fixed income, such portfolios offer stronger return potential and less vulnerability to higher interest rates.

Idea 5  |  Go Active, Be Flexible

A rising rate cycle creates challenges for investors, but it also can highlight the value of active management and a flexible approach.

  • In Equities, the effects of rates and inflation will likely be very specific to sectors, industries and specific companies. There will likely be more dispersion of operating results as companies deal with the impact of higher interest costs. Greater disparity of performance by equity style, as shown below, reflects this trend. If the equity environment becomes choppier, managers should have more opportunities to capitalize on potential mispricings.

Growing Performance Differences Can Benefit Active Managers

U.S. Equity Style Disparity: Best-Performing Minus Worst-Performing

Source: FactSet. Represents the difference in return between the year’s best and worst performing style/market capitalization segments, from among the following indices: Russell 1000, Russell 1000 Growth, Russell 1000 Value, Russell Midcap, Russell Midcap Growth, Russell Midcap Value, Russell 2000, Russell 2000 Growth and Russell 2000 Value.

  • In Fixed Income, the headwind of rising rates coupled with the duration exposure that plagues major market indices reinforces the need for more varied exposures and employing managers with flexible disciplines. Changes in the political backdrop and regulatory/tax environment suggest the need to understand and anticipate changes to come. Using managers with a flexible approach, including the ability to move among sectors, duration exposures and rate markets, could prove valuable in the months ahead.
  • In Multi-Asset Class portfolios, investors can seek exposure across the market spectrum, including the use of alternative income sources for yield with limited duration. Employing both strategic and tactical weightings allows investors to seek long-term returns and capitalize on current market conditions.

Make Your Portfolio ‘Rates Ready’

Security/StrategyPotential BenefitsPotential Issues/RisksNet View
Senior Floating Rate Loans Adjustable yield, high in corporate capital structure Credit risk Favorable yield/duration relationship
Short Duration High Yield Low rate risk, benefits from extended credit cycle Credit risk Favorable yield/duration relationship
TIPS Principal adjusts with inflation, credit quality Complement with higher return assets Undervalued, effective inflation hedge
High Yield Bonds Higher yields, benefit from extended credit cycle Credit risk, spreads have narrowed Helps offset higher rates’ impact, appealing total return prospects
Private Debt Extra yield due to illiquidity Credit risk, long lock-up periods Useful component of an inflation-conscious portfolio
Emerging Markets Debt Higher yields offset rate risk, leveraged to economic growth Currency impacts of U.S. rate gains may hurt returns Particularly through short-duration EMD, provides an appealing risk/yield trade-off
Multi-Sector Fixed Income Flexibility to capitalize on opportunities across sectors and markets; can limit benchmark exposure Credit risk, reliance on manager quality Effective way to address current fixed income environment
Security/StrategyPotential BenefitsPotential Issues/RisksNet View
Equities (General) Earnings tied to economic growth, natural inflation hedge Active focus on sector, security selection is important. Higher rates can eventually trim growth Strong economic growth makes equities a key asset class today
High Dividend Equities Tied to the economy, additional yield for income-oriented investors Active focus on sector, security selection is important. Higher rates can eventually trim growth An effective choice for a high rate environment. Security selection is important
MLPs Income growth tied to the economy, strong energy volumes Short-term sensitivity to oil prices Combine resilience tied to economic expansion and a high yield
Security/StrategyPotential BenefitsPotential Issues/RisksNet View
Private Equity Long-term approach helps focus on holding company fundamentals Extended lock-up, exposure to economy similar to traditional equities Earnings growth can outweigh rate impact over time
Hedge Funds Higher rates show company differences, provide strategy-specific advantages Manager selection, diversification is key Strong performance during periods of rising rates, low correlations to traditional asset classes
Put Writing Should outperform underlying equity index in sideways or down markets In exceptionally strong markets, a put writing strategy will lag equity index Equity-like returns at lower risk; strong performance during periods of higher rates
Security/StrategyPotential BenefitsPotential Issues/RisksNet View
Alternative Risk Premia Use of factors targets specific sources of return, limits risk Use of derivatives adds to complexity, heightens need for manager skill Low correlations, complementary to traditional asset classes
Multi-Asset Income Diversification across assets provides higher yield and return potential while dampening rate/inflation risk Adds non-duration risks, will underperform equity indices in major bull markets Appealing allocation for fixed income investors