Rising Interest Rates and What You Can Do
Soaring inflation. Rising rates. Market volatility. What are strategies for responding not only to the rocky, recent past quarter, but also to the prospect of a rising-rates environment over the next cycle?
Soaring inflation. Rising rates. Market volatility. Many people want to know how to adjust, if at all, their portfolio strategies. The Federal Reserve has commenced an anticipated series of interest rate hikes to stem inflation, and the effects are starting to reverberate throughout financial markets.
What are the portfolio management strategies for responding not only to the rocky, recent past quarter, but also to the prospect of a rising-rates environment over the next cycle? The fixed income allocation of a portfolio is a good place to start.
Are bonds getting too risky?
After digesting the results of the unpleasant first quarter of 2022, you might wonder if your current allocation to bonds is still appropriate.
In conducting this evaluation, you would do well to keep a few things in mind—some obvious, some perhaps not immediately so:
As with most investments, bonds carry risk. But historically, they've had and continue to have lower downside capital risk than stocks. In fact, the magnitude of fixed income drawdowns has paled to that of stocks (See chart below, "Stocks exhibit exponentially more drawdown risk than bonds"). For those who are more risk-averse, this can be a crucial distinction.
Allocation attempts to address multiple types of risk. For example, stocks come with greater drawdown risk, but less purchasing power risk than do more conservative investments. With inflation front-and-center in the news cycle, holding periods, goals, objectives, and behaviors matter.
Stocks exhibit exponentially more drawdown risk than bonds
Annual returns and max intra-year drawdown
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: U.S. bonds as represented by IA SBBI U.S. Intermediate-Term Government Bond Index from January 1, 1970, to December 31, 1972; Bloomberg U.S. Government/Credit Intermediate-Term Index from January 1, 1973, to December 31, 1975; Bloomberg U.S. Aggregate Bond Index from January 1, 1976, to June 30, 2009; and Bloomberg U.S. Aggregate Bond Index Float Adjusted thereafter. U.S. equity as represented by the FT Wilshire 5000 Index from April 1, 1972, to June 30, 1994; MSCI USA Investable Market Index from July 1, 1994, to June 30, 2001; and CRSP US Total Market Index thereafter.
Sources: Vanguard analysis of Morningstar Direct data, as of March 31, 2022.
Before making any significant changes based on recent or anticipated bond performance, you should ask the question, "How does this past recent quarter figure into the long term?" Our analysis shows that for conservative investors, three-year returns through year-end 2021 were significantly higher than historical average returns across most portfolio mixes—including the rough first quarter of 2022 (see chart below, "Did Q1 2022 change the longer-term narrative?").
Did Q1 2022 change the longer-term narrative?
Distribution of rolling three-year returns of U.S. equity/bond portfolios relative to history:
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: Portfolios comprise the Spliced US Bond and Spliced US Equity return series, weighted according to their respective stock and bond allocations. Bond portion of portfolios is composed of Spliced US Bonds, as represented by Bloomberg U.S. Aggregate Bond Index from January 1, 1990, to June 30, 2009; and Bloomberg U.S. Aggregate Bond Index Float Adjusted thereafter. Stock portion of portfolios is composed of Spliced US Equity as represented by the FT Wilshire 5000 Index from January 1, 1990, to June 30, 1994; MSCI USA Investable Market Index from July 1, 1994, to June 30, 2001; and CRSP US Total Market Index thereafter.
Sources: Vanguard analysis of Morningstar Direct data, as of March 31, 2022.
Seize opportunities amid the disappointment
It's one thing to understand how a market cycle is playing out. But it's a different thing to understand the benefits of deliberate, patient action - especially as portfolio balances dwindle. Following are a few things you can do to feel more at ease:
Refocus on the big picture
Focus on your progress toward your goals and your continued ability to meet your goals—remember to view short-term returns from a big-picture perspective, and to keep track of the numbers that represent your long-term objectives.
Evaluate whether your circumstances have changed
Given recent experiences, any change in your risk tolerance might warrant a strategic change in your portfolio.
Are your goals still in reach?
Know that staying the course requires action
Rebalance your portfolio if allocations have drifted out of tolerance bands.
Perform tax-loss harvesting if appropriate.
Use the opportunity to perform portfolio cleanup (review asset location, concentrated positions, and high-cost legacy positions).
Consider Roth conversions where appropriate.
Implement a dynamic spending strategy.
Remember that higher current yields mean higher future nominal returns
The Fed's recent nudge upward of the federal funds rate has increased interest rates throughout the economy—including current yields on bonds. As yields go up, bond prices go down. For bondholders with a need to sell assets prior to maturity in the near term, this relationship is understandably disheartening. But as an investor's time horizon (and potential ability to benefit from higher rates) lengthens, that can be good news.
You may need to evaluate your fixed income investment duration versus the duration of your portfolio's fixed income holdings. (See chart, below, "How might things look from here?" for a hypothetical depiction of return outcomes across a range of potential interest rate changes).
How might things look from here?
Hypothetical impact of changes in interest rates, Q1 2022
This hypothetical example does not represent the return on any particular investment.
Notes: "No change" yields are as of December 31, 2021, based on the Bloomberg U.S. Aggregate Bond Index and "End of Q1 2022" hypotheticals are as of March 31, 2022. For simplicity, duration was assumed to remain at 6.8 years for year end 2021 and 6.58 years for end of Q1 2022; but in practice, as yields change, duration also changes. Such a dramatic change in yields as this example assumes would likely constitute a rather significant adjustment to a fund's weighted average duration. For purposes of illustration, we assumed no change to yields in subsequent years.
Source: Vanguard.
What changes might you consider for fixed income portfolios?
Your situation might dictate a need to search for more productive sources of yield—for instance, if you have a shorter time horizon and more immediate income is a concern. There are various rates and yield curve calls to consider, but they come with caveats.
Rates and yield curve calls
Shorten duration and increase credit exposure—but acknowledge this can lead to a more equity-like portfolio in terms of drawdown risk.
Trade duration—but know that this has not historically been a reliable source of alpha.
Choose to avoid bonds altogether, and instead barbell with cash and equities. But one must factor the considerable likelihood of being wrong on interest rates and improperly timing re-entry into bonds. Predicting rates, historically, has been an activity fraught with off-target forecasts (see the chart, below, "Making the right call on rates has proven difficult").
Making the right call on rates has proven difficult
U.S. federal funds effective rate and forward rates:
Notes: Monthly data are from January 31, 2008, to February 28, 2022. The federal funds effective rate is annualized. Forward rates are based on futures contracts with tenor up to 2 years.
Source: Bloomberg.
Stay focused on long term plans
After a distressing Q1 for bond portfolios, you may need reassurance that your plans still work. In the big picture, three-year returns were, in fact, near the median. Also, keep in mind that while higher current yields mean lower current asset prices, they also mean higher future nominal returns.