As interest rates rise, so, too, do investors’ concerns about the performance of fixed income.
“An allocation to fixed income is considered a safe way to preserve capital and provide diversification against equity investments,” says Vjosana Klosi, director of portfolio construction at CIBC Asset Management Inc. and author of a December 2017 research paper on fixed income and rising rates.
“However, in the current period of rising rates and expected inflation, performance of fixed income is negatively impacted.”
Equities, too, won’t get off scot-free. “When we have a combination of rising rates and slow growth levels, the impact is negative to both equities and fixed income,” says Klosi.
Both asset classes react negatively to rising rates because subdued growth doesn’t offset the negative impact of rising borrowing costs and the removal of liquidity in the market. Klosi’s report illustrated the positive correlation between equities and fixed income in such an environment by reproducing data from the rising-rate environments of the early 1980s and 1990s. During those decades, there was a positive correlation of between 30 and 60 per cent in both Canada and the United States.
As interest rates rise, finding balance through a traditional 60/40 split or a similar approach is harder to achieve. The positive correlation between fixed income and equities “indicates that maintaining debt and equity allocations had reduced diversification benefits during those periods,” Klosi noted in the report.
Still, if investors forgo fixed income due to that challenge, they could miss out on the benefits.
Why fixed income fits the bill
First, fixed income can still provide downside protection.
“This is due to the less-than-perfect correlation between equities and debt,” says Klosi. For example, during the past three financial crises since 1975, equity performance ranged from about minus 30 per cent (September to November 1987) to as low as about minus 53 per cent (November 2007 to February 2009).
“During the same period, government bonds have had positive returns in all three scenarios,” she says. For example, the performance of Barclays’ U.S. aggregate bond index was 2.3 per cent and 11.8 per cent during the above two crises.
Second, in rising-rate environments, fixed-income losses are substantially less than those for equities during times of crisis. For the former, losses “range typically in the negative single digits, and they’ve even been positive in a couple of scenarios of rising rates,” says Klosi.
Finally, the recovery of fixed income is relatively short. “It takes approximately two to three months,” says Klosi. “For equities . . . recovery will take as long as five years.”
Think about the long term
Another thing to consider is rising interest rates partially offset fixed income’s declining price levels, as investors can reinvest coupons and maturing principal at higher rates.
For long-term investors, this means “the overall proceeds at maturity from the reinvestment of your coupons will be higher in a rising-rate [environment] than in a stable or a declining-rate environment,” says Klosi.
Further, the pace of rising rates is expected to be gradual. Historically, during periods where rates increase slowly, “the negative impact to fixed income is very subdued and moderate,” she adds.
Between 2004 and 2006, gradual rate increases actually resulted in positive performance for all fixed-income asset classes. Also, Klosi notes the U.S. Federal Reserve’s federal open market committee has set the long-term projection for its federal funds rate at 2.8 per cent, which is considerably lower than historical targets of four per cent.
It’s also “definitely lower than what we’ve seen in the past during a rising-rate period, where rates have been as high as 20 per cent,” says Klosi.
This article originally appeared on the website of Benefits Canada‘s companion publication, advisor.ca.