Optimal Diversification Portfolio for Upcoming Interest Rate Environment
Although economic circumstances have been difficult over the past few years, the one positive feature has been low interest rates. The ten-year Treasury Note obtained its rate low of 1.43% in July 2012 and since then has traded mainly in the 1.75% to 2.75% range, peaking at 3.04% in December 2013.
Modern Portfolio Theory indicates that in order for a client’s portfolio to be efficiently invested, given the returns available, two or more diversified assets need to be held in the portfolio. In order for the assets to be “diversified,” they must move in somewhat different directions in the same market environment. In other words, the assets must have low correlation to each other.
In a broad portfolio context, stocks and bonds have historically been used as the two primary diversifying assets. Since stocks tend to have the highest returns over time, stocks are usually called the “return asset class.” Since bonds tend to have steadier returns and perform relatively well when stocks decline, bonds are usually called the “diversifying asset class.”
This all works well until bond prices are falling (i.e., interest rates are rising.) We have recently seen the damage that rising interest rates can do in bond portfolios. In the four month period that the ten-year Treasury rose from 1.70% on April 30, 2013 to 2.78% on August 31, 2013, the Barclays US Aggregate Bond Index (the broadest index) declined 3.66%. This was only for a one percentage point increase. Obviously, fixed income securities were not advantageous diversifying assets to own during this period of time.
One of the oldest US interest rate series records AAA-rated corporate bond yields. Since 1919 Moody’s has managed this series. In the chart below, the 96-year history of these yields are graphed. As the arrows indicate, there have been three secular trends in these bond yields:
- Interest rate declined from 6.38% in 1920 to 2.46% in 1946 (after the Great Depression).
- Interest rate rose from 2.46% in 1946 to 49% in 1981 (after the Great Inflation).
- Interest rate declined from 15.49% in 1981 to 3.40% in 2012 (after the Great Recession).
It is evident that interest rates have had three approximately 30 year secular cycles over the past century. We believe that the 2012 low interest rates will hold and that we are at the beginning of the next secular interest rate rise.
Certainly there are macroeconomic reasons for interest rates to rise:
- The Federal Reserve has kept short-term real interest rates low to boost the economy. In the last cycle the Fed did not increase short-term rates above inflation until 1952, six years after the bottom of interest rates.
- The money that is being printed to implement this policy is going mainly into equity and other wealth portfolios. Since these portfolios are spent over time and not immediately, the inflation effects take some time to be realized. In the last cycle, the annual rate of inflation did not rise above two percent until 1966.
- But as the above graph indicates, longer-term interest rates began to anticipate the coming inflation by rising (slowly) to over 3% in 1951 and 4% in 1955. From that point forward, these rates steadily increased into the 1981 high.
Therefore, client portfolios’ need to be prepared for future interest rate increases. They may be mild or even non-existent in 2015 but like 2012, by the time it is clear interest rates are rising, the diversifying portfolio will be losing money.
In order to prepare clients for the upcoming interest rates environment, financial advisors will need to take a multi-allocation approach to invest the non-equity portions of client portfolios and provide effective diversification. It will be important to create income, low long-term interest rate exposure and true diversification to meet these goals. While we recommend that clients maintain their equity investments in the Post-MPT Growth allocation, their bond funds and allocations should be sold and reinvested in all three of the following approaches to create the diversifying portfolio (minimum of $200,000):
- Enhanced cash allocation (50%) – The iSectors Capital Preservation Allocation is comprised of short maturity Treasury, global investment-grade and high yield corporate, and mortgage exchange traded funds (ETFs). This portfolio has a capital preservation objective with expectations for greater return potential than can be provided by money market or cash equivalent portfolios.
- Global conservatively invested balanced allocation (25%) – The iSectors Global Conservative Allocation owns a global investment grade and high yield portfolio to diversify from the potential rise in U.S. interest rates and receive enhanced current yield (75% of the Allocation). The other one-quarter of the Allocation is comprised of a global developed and emerging market dividend oriented equity portfolio for extra yield (higher than that of the Barclays US Aggregate Index currently) and return potential.
- Exchange traded alternatives allocation (25%) – The iSectors Liquid Alternatives Allocation is a portfolio of hedged strategies, private equity, and real assets using ETFs, mutual funds and other exchange-traded securities that should create a return pattern highly diversified from the stock and bond markets while providing attractive income.
Since each client has different objectives and risk tolerance, this model portfolios will not be applicable in every case. Financial advisors are responsible to take this information and determine the best investment program for each client. If you are a financial advisor and would like to discuss a client’s specific portfolio needs, please contact Scott Jones at 1.800.869.5184 or firstname.lastname@example.org.