U.S. interest rates have risen significantly during the past year and some investors may be concerned that U.S. yields will continue to rise in the year ahead. While PIMCO believes interest rates are fairly anchored in the near term due to both a dedicated Federal Reserve and a persistent lack of inflationary pressures, we believe investors can position their fixed income portfolios more defensively. Recognizing that fixed income remains a critical part of most asset allocation structures, expanding into a more global opportunity set can enhance a portfolio’s ability to withstand potentially higher U.S. rates.
Rising rates: How bad can it get?
U.S. Treasury rates rose significantly last year and could rise further, but by how much and when? The rise in interest rates, which have already shot up 130 bps from their all-time lows in 2012, may already be past the halfway mark or near its end. Since 1981, during periods of rising rates, the U.S. 10-year Treasury yield has risen on average 224 bps. While interest rates have fallen over the past 30 years and some say they can really only go up from here, we find no rational argument for a secular mean-reversal — which means they may go up, but by no means need to reverse the trend of the past 30 years. That’s because over the long term, inflation is by far the best indicator of interest rate trends (Figure 1), and a combination of factors has led to a secularly lower profile for inflation than in the 1970s and 80s. These factors include a better supply-demand balance in energy markets, the benefits of increasing globalization and the evolution of Fed policies, which now include more effective tools and more timely transmission to the real economy.
Figure 1 shows that in the long run, interest rates tend to remain above inflation (investors need to earn a real rate of return), but it also shows that the wedge between interest rates and inflation has narrowed on a secular basis. We would argue that this is because over time, the Fed-to-market reaction function has become both more efficient and more credible; it takes a lower interest rate premium today than in the past to hold down inflation expectations. Indeed, while inflation is a driver of interest rates in the long run, monetary policy moves – real or anticipated – are the strongest determinants of interest rates in the short run. In this regard, it’s notable that since 1981, both Fed rate hikes and interest rate increases have become smaller in magnitude (Figure 2). Both the Fed and the markets can move less to accomplish the same goal.
Right now, the market expects the Fed will begin hiking in 2015 and that interest rates will rise by another 200 bps over the following year (based on the difference between the current five-year Treasury yield and the five-year/one-year forward rate). PIMCO believes that the expectations for both higher rates and Fed action are overdone. In our view, the necessary conditions for substantially higher rates are not in place. First, the Fed has not indicated that it is ready to raise rates; instead, it has pledged to keep its policy rate lower for longer in order to help the economy’s transition to a self-supporting recovery, which should act as an anchor for rates. Second, inflation remains well below the Fed’s preferred pace, or target, of 2% (Figure 3) and, in fact, still exhibits signs of disinflation rather than reflation. If this is the case, the current period of rising rates may indeed be near the end.
Given these two factors, PIMCO believes the 10-year Treasury yield is unlikely to exceed 4%: Even if inflation reaches the Fed’s 2% target, the long-term average historical spread between the 10-year and inflation is around 200 bps, which would result in a 4% yield on the 10-year Treasury. In addition, historically, the widest spread between the Fed’s policy rate and the 10-year Treasury has been 400 bps – again, with the fed funds rate at zero, that would appear to put an upper limit on the yield on the 10-year of 4% for as long as the policy rate remains unchanged.
How can I lessen the impact on my portfolio if rates rise?
For the sake of argument, let’s assume the market is right – that rates will rise by another 200 bps. While historically U.S. bonds have suffered losses during periods of rising rates, it is important to recognize that bond losses have generally been much smaller than losses in equities, and investors’ losses are typically offset or recovered in a shorter period of time as investors have the opportunity to reinvest in higher-coupon bonds. That would likely be the case if the market’s expectations play out: A 200-bps rate shock would result in a 5.2% loss on the Barclays U.S. Aggregate Bond Index, but we estimate that loss would be fully recovered in just over a year.
Despite this more encouraging outlook, we recognize fixed income investors can be sensitive to any losses and are looking for ways to avoid or minimize them.
We think opening up a fixed income portfolio to global bond markets can potentially lessen the impact of rising U.S. rates through the benefits of diversification. Global diversification may help mitigate losses through two channels – differentiation in monetary policies and financial market responses. In the first instance, despite increasing globalization, we still see a world characterized by multi-speed growth and consequently diverging paths for monetary policies.
Figure 4 shows the degree of policy normalization currently priced in across various global bond markets. Notably, while policy rates are expected to remain well-anchored in the near term, markets have begun to price in divergence over the longer term. Stronger economic data in both the U.S. and U.K. have caused the markets to price in a more rapid pace of policy normalization in those countries than in a still-weak eurozone and Japan. In essence, rising rates in the U.S. do not mean rates will rise elsewhere – and in some places, they could fall.
As for market responses to rising U.S. rates, a look at historical data suggests the relationship is not one-to-one, but rather, U.S. rate increases often result in much smaller increases elsewhere. For example, in periods of rising rates since 2002, an increase of one percentage point in U.S. 10-year yields resulted in a 0.60% increase in German yields and an even smaller 0.30% increase for Japan (Figure 5). More recently, the 127-bps rise in U.S. 10-year yields in 2013 was met by a smaller 61-bps rise in German yields, while comparable Japanese government bond yields actually fell. Given these historical relationships, our estimates show that a 200-bps increase in U.S. interest rates would cause a 5.2% decline in the Barclays U.S. Aggregate Index, but a smaller 4.3% decline in the Barclays Global Aggregate Index over one year.
What are the portfolio changes I should consider?
Global diversification offers more than just a defense against rising U.S. interest rates. In addition to mitigating downside risks to rising U.S. rates, exposure to global bonds can also potentially reduce volatility and enhance returns through higher yielding foreign bonds, for example. And depending on an investor’s risk profile and current portfolio allocations, there are a number of global bond choices that can help diversify fixed income exposures by adding exposure to different countries, issuers and types of securities – including any variety of developed and emerging markets assets.
By focusing mainly on domestic markets, most investors have access to a relatively small slice of the global bond market. For example, the U.S. represents just 35% of the roughly $100 trillion global bond market. Adding exposure to developed market global bonds, such as Japan, may reduce volatility in an overall portfolio, while adding bonds in higher yielding developed markets, such as Australia, can potentially enhance returns.
Although not discussed in this paper, exposure to emerging markets can further diversify portfolios with the potential to enhance yields. To be sure, differentiation is likely to continue and even expand across such countries and credits, and there could be further episodes of volatility, but an active manager with expertise in the space can adjust country/currency decisions in anticipation of local and global developments.
In a nutshell, through global diversification, investors gain exposure to different types of bonds that can reduce the concentration of risks within the portfolio and potentially increase returns.