2021 was the worst year for the broad-based bond market since the Greenspan Fed hiked short-term rates by 300 basis points (1 basis point is equal to one, one-hundredth of a percent) … until this year.  The Federal Reserve Open Market Committee has increased short-term rates by approximately 2.75% so far this calendar year, with an expectation that the Fed Funds rate will end the year north of 4%.  This will make the current twelve-month portion of the tightening cycle the fastest, highest series of hikes since the late 1980s. So, how can we, as investors, take advantage of these newly high(er) interest rates within our portfolios both from an asset allocation standpoint and in individual investment alternatives?

MALCOLM POLLEY | PRESIDENT AND CHIEF INVESTMENT OFFICER | STEWART CAPITAL ADVISORS

In general, interest rates and asset values move in opposite directions.  Therefore, as interest rates have risen, asset values have declined.  To take advantage of higher rates, we need to answer a couple of questions: Are higher rates simply part of a normal cyclical interest rate cycle and/or are they part of a longer-term cycle that has greater return consequences?

If higher rates are simply part of a shorter-term cyclical interest rate cycle, then our overall asset allocation doesn’t need to change much.  That is because it is nearly impossible to accurately predict the timing of short-term cycle changes (from rising to falling or falling to rising rates) and missing out on the best few days can dramatically, negatively impact returns. Maintaining your allocation through these short-term rate swings, particularly if you have time on your side, is the best option. If, however, the rising interest rate cycle is part of a longer-term cycle, then investors would be better served to alter their asset allocation to favor shorter duration assets.

Investors have grown accustomed to very good returns from bonds over the last several decades.  According to data provided by NYU professor Ashwath Damodaran, Treasury bonds have provided annual returns averaging 7.36% from  1984 through 2021 – a period that encompasses generally declining interest rates.  However, when we look at average T-Bond returns for the period from 1940 – 1983, the average return drops to just 3.54%.  The difference is primarily due to the fact that from 1940 – 1983, interest rates were on a generally rising trajectory. As indicated above, when interest rates rise, prices (in this case bond prices) fall.

If we are, as we believe, at the beginning of a multi-decade period of generally rising interest rates, then investors should shift their asset allocation to favor shorter duration assets across asset classes.  This means focusing on shorter-term bond investments and equity investments that favor more current cash flows in the form of earnings, dividends or both.  Lower duration equity securities are often viewed as value oriented companies.

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