Download Rising Interest Rates: The Big Picture Written by Alexander Hart

Rising Interest Rates: The Big Picture
Written by Alexander Hart; Director, Equity and Fixed Income Research
Federal Street Advisors
Intro:
While macroeconomic news out of China, and the price of oil has dominated the most recent financial
market headlines, the U.S. Federal Reserve policy has been a subject of debate and intense focus for
years. Investors, bankers, economists and reporters alike are fixated on every word the Federal Reserve
and its board of Governors releases. The examination of, and some might argue obsession with, Fed
statements has reached a point where the market can rapidly change direction based on just an
alteration of word choice, even when the overall message remains the same. These statements garner
so much attention because traders and investors are trying to gain an edge in predicting when interest
rates will rise. Setting aside the debate on when the exact date of an interest rate hike might be, this
paper examines what rising rates mean for your investment portfolio and argues that the long-term
benefits are something investors should welcome not fear. In order to examine this in detail, we first
must have a good understanding of how the Federal Reserve works and why its policy affects interest
rates.
What is the US Federal reserve and why does it matter?
The U.S. Federal Reserve Bank (commonly referred to as the Fed) is the central bank of the U.S. financial
system and its primary function is to enact monetary policy that helps to stabilize and improve the U.S.
economy. The Fed’s three main objectives are: to maximize employment, keep prices of goods stable,
and moderate long-term interest rates. As the economy goes through cycles from economic booms to
recessions, the Fed takes action to moderate the booms and minimize the probability and depth of
recessions. One of the key tools the Fed uses to keep the economy stable is interest rates. In this case,
interest rates reflect the yield paid to buyers of U.S. Treasury bonds. The Fed can influence the level of
interest rates by buying large quantities of Treasury bonds on the open market, thereby pushing prices
of the bonds up and yields down and vice versa. In general, the Fed will increase interest rates in order
to slow down the economy and decrease them to stimulate growth.
Why do investors fear rate increases?
Investors have feared the prospect of rising interest rates for two main reasons: the potential for slower
economic growth and negative returns for bonds. The Federal Reserve uses higher interest rates to slow
the economy by increasing the cost of doing business and buying a house. Companies looking to build a
new factory or invest in new technologies often raise funds for these projects by issuing bonds. As
interest rates rise on Treasury bonds they rise correspondingly on corporate bonds, increasing the cost
of financing for companies. As the cost of financing increases, companies are less likely to invest in new
projects, slowing the economic growth rate of the economy. Similarly as interest rates rise on Treasury
bonds, the interest rates for mortgages on homes also rise. This increases the monthly payment
required to build or own a home, subsequently slowing the pace of growth in the housing market.
While we think this is a legitimate concern in the long run because slowing economic growth can act as
an impediment to earnings growth and stock prices, at this point in the interest rate cycle the effects
should be limited.
Interest rate changes don’t just affect the economy; they can also have sudden and material impacts on
performance of investment products. Interest rates and the prices of bonds have an inverse
relationship, as rates rise bond prices fall and vice versa. During the past 30 years, investors have
enjoyed a long cycle of declining interest rates. In September of 1981 the 10-year Treasury Bond peaked
at an interest rate of over 15%. Since then, interest rates have been steadily declining, producing an
environment of sustained strong performance as bond prices rise. The U.S. Barclays Aggregate Index
has delivered an annualized return of nearly 8% over that time span, with only a few short periods of
mild negative returns, conditioning investors to expect strong consistent positive returns in fixed
income. Many fear that when the Fed changes its policy and begins to raise interest rates, negative
bond returns will cause widespread selling of fixed income products causing further declines in bond
prices. This concern is certainly warranted and we have positioned our clients’ portfolios to protect
against this risk, however, we continue to believe that higher interest rates is a healthy outcome for
investors and the market in the long-run.
What are the benefits?
At Federal Street Advisors, we believe that rising interest rates do present real near-term risks that
investors should be prepared for but recognize that higher interest rates will also bring long-term
benefits to those who are well positioned. Higher interest rates are an indication of economic strength,
improve income available for investment products, and promote rational capital markets.
While the Federal Reserve does use higher interest rates to slow economic growth late in a business
cycle, it is important to understand that the potential upcoming interest rate hike is not an attempt to
slow growth but rather to return interest rates rate to a normalized level. During the financial crisis of
2008/2009, the Federal Reserve lowered their interest rate policy target effectively to zero where it has
remained since then. This was a historically extreme measure designed to promote business
investment, stabilize the housing market, restore confidence in the stock market and stimulate
economic growth. The Federal Funds target interest rate (the interest rate that the Fed targets for
monetary policy) has been 0%-0.25% since December 16th, 2008, well below its long run average of
7.4%1. An increase in the Fed’s target interest rate today would be indicative of their confidence in the
economic strength and stability as they seek to bring interest rates to a normalized level, and not an
attempt to slow the growth rate of the economy.
While a declining interest rate market has resulted in strong performance from bonds, low absolute
levels of interest actually significantly reduce the potential for future returns. One of the primary goals
of a zero interest rate policy is to reduce the cost of financing for companies. Companies have been able
to issue bonds to investors at all-time low interest rates. While this is a good deal for companies, it’s not
a great outcome for investors, who are forced to take increasingly lower compensation for the risk of
lending this money. The yield on the Barclays U.S. Aggregate Index was just 2.3% as of September 30th,
compared to 6.6% twenty years ago. Low coupon rates generally mean poor opportunities for returns
and more recent results have reflected that as the Barclays Agg has returned just 1.7% in the last three
years. While an increase in interest rates will likely result in negative returns for bonds in the near-term,
it greatly improves the long-term return potential by allowing investors to reinvest coupons at higher
interest rates. In our estimation, investors in the Barclays U.S. Aggregate Bond Index might experience a
drawdown of as much as 7.5% if interest rates were to rise by 2%, but would still be expected to achieve
a 10-year annualized return 0.7% higher than a scenario in which interest rates remained unchanged
and no drawdown occurred2. This scenario analysis highlights both the importance of protecting against
the near-term risks of an interest rate increase but also the improvements to long-term total return
opportunities.
Low interest rates can cause investors to take on more risk:
Sustained low interest rates also have significant impacts on investor behavior, which can cause
imbalances in the capital markets. Low interest rates means the retiring baby boomer generation in
particular are not able to depend on the same level of income from their municipal bonds portfolios.
Due to the lack of income in bonds, these investors have been forced to buy areas of the equity market
that pay dividends, such as the utilities sector, but may expose themselves to more risk than is
appropriate as a result. Increases in interest rates will bring increases in income from bond portfolios,
and allow investors with lower risk profiles to return to more suitable asset allocations.
Pension funds will also benefit from a rising rate environment. These funds are required to report an
estimate of the value of their future obligations to pay benefits to retirees. Since the bulk of these
payments will occur in the future, they use a “discount rate” to calculate the value of the future
payments in present terms. This discount rate is tied to the prevailing interest rates in the market.
Lower interest rates means a lower discount rate, which results in larger future obligations. As interest
rates fall, the pension fund’s financial health deteriorates and they are also forced to adopt a more
aggressive or risky asset allocation to achieve the returns needed to pay retirees. Conversely, if interest
rates rise, pension funds should regain healthier financial conditions, the risk levels of their investments
can be reduced, and payments to the beneficiaries will ultimately be more secure.
Active management will benefit:
Sustained low interest rates have also presented challenges to the performance of active managers
through the encouragement of irrational investor behavior and unsustainable low financing costs. While
influencing the equity markets is not a stated goal of the Federal Reserve, it is an outcome of their zero
interest rate policy. As described previously, low income and poor total return expectations in bonds
have pushed fixed income investors into buying stocks in the utilities sector. In 2014, as interest rates
fell, this sector returned 29%, outpacing every other sector in the market. Active managers were
broadly underweight the sector on fundamental concerns that high relative valuations and chronically
low growth rates posed significantly greater risk than the promise of 3-4% of income. In this
environment, active managers posted one of the worst years of relative performance on record (link to
previous paper here?).
In addition to changing investor behavior, low interest rates offer greater support to companies in poor
financial condition making it more difficult to separate good investments from bad ones. Low interest
rates mean low financing costs for companies raising money through the issuance of bonds. This low
cost financing benefits companies in poor financial condition or those that have been mismanaged
disproportionately to high quality, well-run business. The best-run companies are typically rewarded
with low financing costs in all market environments, or in many cases do not need to rely on debt
financing at all because they are able to fund new projects and investment from cash flow from their
existing business. A decrease in interest rates has little effect on the cost structure of these companies.
Conversely, when interest rates are low, low quality companies that need to raise cash from the debt
markets are able to do so at lower costs than ever before. The stocks of these low quality companies
can be rewarded in low interest rate environments as their fundamentals appear improved, but as
interest rates rise and the costs of financing increase, these results will be unsustainable. While the
style of active managers can vary, most look to buy companies with superior business models and strong
management teams, which should benefit on a relative basis as interest rates rise leading to active
manager outperformance.
Conclusion:
Given the attention the media gives the topic it is easy to get caught up in the intense debate of when
the Fed might raise interest rates, but as recent history has shown it is difficult to predict. In the
beginning of 2014, 46 economists polled by the Wall Street Journal expected the Federal Funds rate to
be an average of 1% by the end of 2015 and yet today the effective rate remains roughly 0.1%. At
Federal Street Advisors, we believe the game of attempting to time an unpredictable interest rate rise is
not one that our clients will benefit from playing. While we recognize that there are near-term risks to
bond portfolios associated with an interest rate increase, it is increasingly important to keep the big
picture in mind: a higher interest rate environment is both inevitable and healthy for the market, and
investors who are well prepared will benefit.
1
"Historical Changes of the Target Federal Funds and Discount Rates." Federal Reserve Bank of New
York, n.d. Web. 30 Oct. 2015. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html
2
Analysis assumes a parallel shift in the yield curve occurring evenly over the first 12 months with
income being reinvested at higher rates. Full scenario analysis is available upon request.