Impact of Rising Interest Rates on Investment Portfolios
*Sigh* It has been a year… so far. All three major indexes were down at least 20% as of the end of the third quarter, driven by geopolitical crisis, leftover supply chain effects from COVID-19, and myriad more economic uncertainties. Adding fuel to this raging fire are the record levels of inflation, causing a natural response by the Fed to raise interest rates as they attempt to correct this unnatural pace.
But what could these rising interest rates mean for investors with a traditional portfolio mix of equities and fixed income, and what could it mean for those allocated to alternatives?
One of the most traditional, classic portfolio allocations that an investor can have is the 60/40: 60% allocation to equities, and 40% to bonds. Simply put, the thought process for this strategy is that investors get upside from equities, and risk protection from bonds. The negative correlation between the two historically has made the strategy easy, safe, and viable for many long-term individual investors with a goal of moderate risk for moderate returns. Unfortunately, this concept from a risk-return perspective has been tested in 2022, as both stock and bond indexes are currently negative for the year. According to investment research firm Callan, if both indexes end the year with a negative return – which seems likely as we begin the fourth quarter – it will be the first time this has happened since 1969. When examining the 2022 returns of the 60/40 portfolio, only two years (which occurred during the Great Depression) have provided worse returns: 1931 and 1937. To make matters worse, according to Meg Faber, Co-founder and Chief Investment Officer of Cambria Investment Management, “on an after-inflation ‘real’ basis, this is currently likely to be the worst year ever for a traditional 60/40 stocks and bonds portfolio.”
Now, how do rising rates affect portfolios? For most investors in traditional portfolios, rising interest rates can have adverse effects on their holdings. Typically, the stock market falls when interest rates rise as investors flee from riskier equity assets and move into fixed-income assets, where they are able to achieve a decent return for far less risk. However, as stated by Forbes, investors in a 60/40 portfolio may also run into issues with part of their bond allocations in a rising interest rate environment. Most traditional investors diversify their bond allocations by duration (short-, intermediate-, and long-term bonds). In a rising rate environment, shorter-duration bonds which often have lower yields, are best equipped for rising rates, as they have far less interest rate risk relative to their longer-duration bond counterpart. As shorter-duration bonds become more attractive to investors, and demand increases, longer-duration bonds will come down in price to compete. While diversification is always a good idea, the reality of rising interest rates’ effects on bonds shows how the benefits can be offset when the Fed raises rates.
Invesco published a report expanding on this pain being felt by the traditional portfolio, noting that “investors are justifiably concerned that the bastion of the 60/40 portfolio is not suitable for a period of rising inflation and interest rates.” The report questions if persistent inflation and rising rates are the “death knell” of the 60/40 portfolio and suggests the need for different sources of growth and income. These sources include alternative asset classes, such as private real estate, real assets, and private credit, that can reduce downside exposure in the event of a market sell-off and increase the probability of outperformance in these market conditions.
Forbes takes the argument for alternatives and broadens the scope to include the previously mentioned asset classes as well as hedge funds, private equity, and infrastructure. The article cites several reasons why some investors are shifting towards adding these types of alternatives to a portfolio, such as diversification, higher growth, high risk-adjusted returns, reduced volatility, low correlation to public stock and bond markets, and as an inflation hedge. In the current environment of high inflation and rising interest rates leading to a sharp decline in public stock and bond markets, the final two named benefits feel particularly important.
Earlier this year, a report on enhancing the traditional 60/40 portfolio was released by alternative asset manager KKR. The goal of the report was to test a theory on a new mix of asset allocation for investors to consider; a portfolio with a mix of 40% publicly traded stocks, 30% bonds, and 30% private assets (including the aforementioned alternative investment asset classes). Henry McVey, Partner & Head of Global Macro and Asset Allocation, and Racim Allouani, Head of Portfolio Construction, Risk Management and Quantitative Analysis, co-authored the report, which compared the suggested portfolio against a traditional portfolio allocation. The comparisons were made in three scenarios: one of low-inflation, one of high-inflation, and one representing all periods. The suggested portfolio mix including a 30% allocation to alternatives, performed markedly better than a traditional 60/40 in a higher-inflation environment. KKR also notes the firm’s expectations of 8% inflation in 2022 and 3.5% inflation in 2023.
The ‘60/40” With Private Markets Outperforms the Traditional ‘60/40’ On a Risk-Adjusted Nominal Return Basis in All Environments
Portfolio returns and volatility modeled using annual total returns from 1928 to 2021 for the S&P500, from 1978 to 2021 for Real Estate, from 2004 to 2021 for Infrastructure, from 1928 to 2021 for Bonds, and from 1987 to 2021 for Private Credit. Assumes continuous rebalancing of the portfolios. US equities modeled using the SP500 Index. Bonds modeled using a mix of 50% US T.Bond and 50% Baa Corp Bond annual returns, computed historically by Professor Damodaran (NYU Stern). Real Estate modeled using the NCREIF Property Levered Index. Private Infrastructure modeled using the Burgiss Infrastructure Index. Private Credit modeled using the Burgiss Private Credit All Index.
Source: KKR
Many alternative investment strategies are built for an environment of rising rates and high inflation. While such strategies are subject to substantial risks and complexities in which future performance can never be guaranteed, the chaos of markets can be a boon for those with the expertise and design to take advantage. According to Kenneth Tropin, Chairman and Founder of Graham Capital Management, “rate changes and market volatility don’t happen in lockstep across countries and regions, creating macro strategy opportunities in markets like fixed income, foreign exchange, commodities, and emerging markets.”
A recent article from Pensions & Investments highlights other hedge fund strategies that are well-positioned to provide long-term resilience to investors’ portfolios. Fixed income relative value and arbitrage strategies take advantage of inefficiencies within credit markets, finding opportunities amongst anomalies from investor reactions to the macro environment. Merger arbitrage also does well when rates rise, according to Darren Wolf, Global Head of Investments for Alternative Investment Strategies at abrdn. Wolf explains that merger arbitrage has historically done well in rising interest rate environments as “the higher the interest rates, the bigger the discount rate and the more significant that spread will be before the deal closes.”
Private equity portfolio companies may undergo some repricing, but historically the industry has felt less pain than public markets during rising interest rate environments. The co-head of private equity at a Franco-German investment fund recently told Private Equity International that they are not worried about a rising interest rate environments’ effect on the industry’s ability to generate good returns for investors. They explained that “new deals will reflect the interest rate environment you’re in and assets will be repriced… For new stuff, I don’t see any need to think about lower returns.” Now is as good a time as any to consider an allocation into a portfolio.
A constant theme amongst investors is that diversification is key if one wants to avoid getting caught up in market volatility. As we have seen this year, a paradigm shift now means that a traditional mix of stocks and bonds may not be enough to diversify away from the pain of inflation and rising interest rates. While such strategies are subject to substantial risks and complexities in which future performance can never be guaranteed, the chaos of markets can be a boon for those with the expertise and design to take advantage. Stock and bonds are cornerstones of a portfolio, yet data indicates that some investors are beginning to consider allocating to alternative investments, such as hedge funds, private equity and private credit across a variety of strategies and vintages, that have demonstrated an ability to survive and thrive in rising interest rate environments.
Sources:
CNBC, October 2022. “This classic investment strategy is on track for its ‘worst year ever’ – here’s what to do with your money.”
Forbes, October 2022. “Ten Reasons Investors Consider Investing In Alternative Assets.”
PEHub, September 2022. “Rising interest rates may not mean lower returns on new deals.”
Pensions & Investments, September 2022. “An Opportune Time for Hegde Fund Strategies.”
Pensions & Investments, September 2022. “Why ‘everybody’ is talking about global macro.”
Forbes, September 2022. “Why Are Interest Rates Going Up? Here’s What Investors Need To Know About It.”
Crystal Capital Partners, July 2022. “The Role of Private Equity During Market Downturns.”
Invesco, May 2022. “How can alternatives act as a hedge to rising rates and inflation?”
KKR, May 2022. “Regime Change: Enhancing the ‘Traditional’ Portfolio.”
Barron’s, May 2022. “Move Over, 60/40 Portfolio. You’re Out of Date Now.”
Callan, May 2022. “Unprecedented Territory – and the Inherent Limits of Diversification.”
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