Rising rates shouldn't trump diversified approach

A rise in interest rates has resulted in an average quarterly loss of 0.1% in the Barclays Capital U.S. Aggregate bond index, but the impact on equities and other assets classes was positive, according to a Wilshire Associates Inc. analysis released Aug. 15.

The recent jump in interest rates “has stoked concerns” of a potential reversal of the long-term trend in a decline in yields and that will lead to falling bond prices and returns, the study said.

But the “average returns to equities have held up well during periods of rising nominal rates,” as did returns of other asset classes, according to the study. Most other asset classes, including high yield, benefited on average more in periods of rising nominal rates than in times of decline, according to the study, which attempts “to shed some light on the historical behavior of various asset classes to short-term changes in interest rates.”

Wilshire analyzed the quarterly effect on total returns, including interest and dividends, of changes in nominal interest rates over 20 years, ended June 30. Looking at the 40 quarters of rising interest rates during the period, Wilshire found:

• The Barclays Aggregate returned an average quarterly loss of 0.1%. The impact ranged from a 1.8% gain to a 2.9% loss.


• The Wilshire 5000, however, returned an average gain of 4.5% with returns ranging from 21.5% to -10.6%.

Among other asset classes, the average return was positive during the quarters of rising interest rates, albeit with a wide range of returns:

• The MSCI All-Country World Index ex-U.S. index was up 5.1%, with returns ranging from 27.9% to -10.6%.


• The Wilshire REIT index was up 2.9%, with returns ranging between 31.7% and -33.9%.


• The Barclays U.S. TIPS index was up 0-2%, with returns ranging from 5.5% to -7.1%.


• The Bank of America Merrill Lynch High Yield Master II index was up 2.6%, with returns ranging from 23.2% to -2.3%.


• The UBS Commodity index was up 3.4%, with a range of 17.6% to -13%.


• A diversified portfolio returned 2.7%, with returns ranging from 14.5%% to -5.5%.

“Clearly there is a very direct relationship between interest rates and the return on high-quality bonds,” said Steven J. Foresti, managing director and head of research in the consulting division of Santa Monica, Calif.-based Wilshire, who co-authored the 16-page study.

“When you have ... increases in rates you see fixed income perform poorly, or vice versa when rates go down,” Mr. Foresti said in an interview. “There is a strong” correlation.

“Beyond high-quality fixed income, the relationship isn't strong” with other asset classes, that is, rate rises result in falling prices.

“If I think yields are going up, that's clearly a negative environment for bonds,” Mr. Foresti said. But do you “lighten up on bonds? That's taking a pretty large bet on that environment being realized,” noting the drivers of rate changes, such as inflation or growth expectations, can define the prevailing investment environment and impact on asset classes. Equities have a low sensitivity to rate changes, the study notes.

A rise in nominal rates because of growth expectations is likely to have a positive effect on equity returns, “while an increase in nominal rates from higher inflation expectations could have a negative short-term impact on stock returns,” the study said.

“High quality fixed-income securities, on the other hand, will have a more predictable and uniform response to nominal rate changes, no matter the underlying driver.”

For anyone “who thinks rates are going up, it's important to determine” the nature of the changes, Mr. Foresti said.

“Asset classes react to nominal rate changes differently, based on whether the change was driven by a move in real rates, inflation expectations or some combination of the two,” the study said.

“What is comforting to investors who invest in a diversified portfolio is that ... there is a very weak relationship” between other asset classes and interest rates, Mr. Foresti said.

“A diversified portfolio is not doomed if rates move in a particular direction.”

In the 40 quarters of declining interest rates, the Barclays U.S. Aggregate index returned on average 3%; the Wilshire 5000, 0.5%; the MSCI All-Country World ex-U.S., -1.2%; the Wilshire REIT index, 3.4%; the Barclays U.S. TIPS index, 2.9%; the Bank of America Merrill Lynch High Yield Master II index, 1.4%; the UBS Commodity index.-0.4%; and a diversified portfolio, 1.2%.

The study said “with the exception of high-quality bonds, even investors with a strong view on the direction of future interest rates (i.e., who believe "they're sure to go up') would have a difficult time converting those views into pinpoint projections of asset-class behavior. As with most investment pursuits, the dispersion in results further supports the benefits of taking a diversified approach to portfolio construction; even for those investors with an opinion on rates.”