How to Prepare Portfolios for Rising Interest Rates
From: FlexShares.com
Historical data helps identify assets that may be positioned to fare well when higher rates threaten fixed-income and equity returns
For a good illustration of how investors typically react to the prospect of higher interest rates, look at what happened in January 2022. News that the US Federal Reserve (Fed) might begin raising rates as early as March sparked market volatility that helped to drive general US stocks to their worst monthly performance since March 2020. Bond prices also fell, with yields on the 10-year Treasury recording their largest monthly increase since March 20211.
Now, with higher interest rates widely expected, many investors are worried about the potential impact on their investments — and wondering how they should prepare their portfolios. For insights, we can examine how different asset classes have performed during previous periods of rising interest rates.
Our research into the past four Fed rate hike cycles (2015, 2004, 1999 and 1994) suggest that high-yield bonds, factors such as value and quality, and natural resources investments may be well positioned for stronger returns during risingrate environments.
Fixed Income: Watch Duration and Consider High-Yield Bonds
Because rising interest rates hurt the prices of existing bonds, investors are likely to focus on the potential interest rate risk in their fixed-income allocations. During Fed tightening cycles, the market has historically anticipated rate increases and prices them into the bond market before they happen. Yet there’s always uncertainty about the timing, size, and number of rate hikes, which may create additional volatility if actual rate hikes don’t match the market’s expectations.
Managing duration in a fixed-income portfolio is one way to address this uncertainty. Our research has found that duration is responsible for the majority of expected returns in fixed-income assets, and bonds with shorter durations are often less sensitive to rising interest rates. So, in rising rate environments, positioning fixed-income holdings on the shorter end of the duration curve may reduce risk.
