Interest rates are on the rise. The Federal Reserve approved its first interest rate hike since late 2018 on Wednesday — and there are likely six rises coming this year.
While it’s conventional wisdom that bond yields move opposite interest rates, new research from Morningstar shows why traditional portfolio diversification techniques don’t work as well when interest rates climb.
That’s because the correlation between stocks and bonds also increases when rates spike, exactly the opposite of what’s needed for diversification. Morningstar offers some tactical moves that investors can use to optimize their portfolios for coming rate hikes, but patient investors with long-term time horizons may still be best suited to stick with traditional diversification of stocks and bonds.
A financial advisor can help you plan for changing interest rates and gird your portfolio against inflation. Find a trusted fiduciary advisor today.
Why Interest Rate Hikes Make Diversification More Difficult
To understand why portfolio diversification becomes more challenging when interest rates rise, an investor first must have a general understanding how securities move in relation to each other. This is known as correlation.
Securities can be correlated either positively, meaning they generally move in the same direction, or negatively, meaning they move in opposite directions. For instance, stocks that typically go up and down in value at the same time have a positive correlation. Conversely, those that move in opposite directions are negatively correlated.
If a well-diversified portfolio relies on bonds to act as a counterweight to riskier stocks, that balance becomes more difficult to achieve when rising interest rates place greater stress on bonds, especially those with longer durations.
“Generally, correlations between stocks and bonds increase when the market expects borrowing costs to climb,” Morningstar wrote in its 2022 Diversification Landscape report. “This is because a bond’s yield calculation, which is directly affected by interest rates, comprises a large portion of the security’s perceived value. Longer-maturity bonds that carry significant duration (a measure of interest-rate risk) are at a disadvantage.”
As Morningstar notes, 10-year U.S. Treasury bonds are a “practical proxy” for interest rate movements. Between 1950 and 2021, the decades with the highest monthly 10-year Treasury bond yields were also the decades (1970s, 80s and 90s) when stocks and bonds were most positively correlated.
How to Diversify During Interest Rate Hikes
So what’s an investor to do when interest rates are on the move upward? The Morningstar report offers several ideas. First, investors seeking to maintain a diversified portfolio may consider transitioning out of longer-duration bonds/funds and into intermediate- or short-duration bonds, the report suggests.
Floating-rate funds, which invest in bonds whose interest rates change based on external benchmarks, may also be an option when rates are expected to rise. However, Morningstar notes that floating-rate funds come with more credit risk than a government bond.
Then there’s what Morningstar calls “niche exposures,” like gold and equity neutral market funds. These assets can be good options for investors seeking low correlations to stocks and more diversification than what bonds offer. But like floating-rate funds, they come with their own risks, the report adds.
“Gold prices are heavily influenced by sentiment, and it’s during market crises that gold gains an allure,” the report says. “Equity market neutral strategies are difficult to get right and many offerings have inconsistent performance profiles. Ultimately, niche exposures along these lines are for investors who understand the risks.”
The fourth, and perhaps most suitable alternative, may lie in actively managed bond funds. Actively managed funds have more flexibility than index funds and can avoid the pitfalls of rising interest rates, Morningstar notes.
However, there may be no substitute for high-quality bonds and a 60/40 portfolio, even when interest rates are rising. In the three decades when the correlation between stocks and bonds was highest, the relationship never exceeded 0.5 (the maximum correlation is 1.0).
“Most importantly, during longer time horizons, including periods of stable or falling rates, the diversification benefits between stocks and bonds significantly improves a portfolio’s risk-adjusted returns,” the report concludes. “From 1950 through the end of 2021, the risk-adjusted returns (as measured by a Sharpe Ratio) of a 60/40 portfolio came out ahead of the individual stock and bond components.”
If your time-horizon is long, then, there’s probably less need to stress about exactly your asset allocation will weather the rising-rate environment. “So rather than obsessing over a period of rate rises, patient investors should trust diversification over the long term,” the report says.
Bottom Line
The Federal Reserve increased interest rates for the first time since 2018 on Wednesday when the target federal interest rate went from 0-0.25% to 0.25-0.50%. The rate hike is the first of seven increases expected in 2022.
Morningstar found that when interest rates rise, the correlation between stocks and bonds also increases. This makes diversification within portfolios more challenging. However, investors may consider tactical moves like rotating out of long-duration bonds and into shorter-duration ones, investing in floating-rate funds, as well as actively-managed bond strategies.
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