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.

FRED 10-YEAR TREASURY

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:

FRED Moody's

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:

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):

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 scott.jones@isectors.com.

 

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