“It’s hard to define, but, you know, it probably means something on the order of around six months or that type of thing.” – Fed Chair Janet Yellen
That comment by the new chairwomen of the Federal Reserve sent shock waves through global financial markets. Janet Yellen was answering a question about when she estimated that interest rates would begin moving up. She said she expected the Fed’s bond-buying spree would end in October, and rates would start heading north a half year after that. I’m not exactly sure why that was so surprising. But for investors, that means we are about to enter a new reality, and a repositioning of investments is called for.
What should you do?
Flashback a year ago when all the “taper” talk started. It didn’t take long for bonds to get hammered, as the 10-year US Treasury bond yield jumped from 1.5 percent to around 3.5%. Bond holders saw their holdings drop by 5% to 10% – not exactly the kind of volatility you would expect from a “conservative” investment. If the Fed actually raises rates, the carnage could be worse. The question then is what to do? For the fixed-income allocation of the portfolio, the first tip is top go global. Believe it or not, investing in foreign bonds provides both value and stability. It’s all about the business cycle.
According to Alison Martier, senior portfolio manager of fixed income at AllianceBernstein: “A US-only bond investor is affected by one business cycle, one yield curve and a single monetary policy. As long as rates were falling, that seemed like a good thing. Not so these days. Going global diversifies an investor’s interest-rate risk – and brings many other potential benefits. Although different countries’ economic cycles, business cycles, monetary policies and yield curves may briefly align, over long periods they’ve not been highly correlated. The array of country returns differs significantly each year. And so do future opportunities – and risks. If that sounds worrisome, think again: Your own country is part of this mix, and if you’ve got a home-centric portfolio, it’s riding rough seas without ballast.”
While we may think foreign bonds are speculative and very volatile, surprisingly they are not. According to Douglas Peebles, chief investment officer and head of fixed income at AllianceBernstein: “Since 1990, US bonds have averaged returns of 2.5% in positive-return quarters; global bonds offered 2.3% in the same quarters, capturing 92% of the upside of US bonds. That’s because global government bonds tend to move together in widespread flights to quality.”
“In adverse bond markets, however, there has historically been a greater performance gap, with global bonds faring significantly better than US bonds,” he adds. “While US bonds declined 1.1% on average in down quarters, global bonds lost only 0.7%. That’s 62% of the downside of US bonds – a significant advantage.”
Search for growth
Regarding the equity side of your portfolio, research indicates that in rising interest-rate environments, investors would be wise to look at growth stocks. According to investment management firm Lord, Abbett & Co. LLC: “[R]eturns for different equity segments during seven periods between September 1993 and December 2013, when the yield on the 10-year Treasury note was rising significantly, [vary greatly].
Growth stocks (as measured by the Russell 1000 Growth Index) led the way with a median return of 31.2%. At the other end of the spectrum, high-dividend stocks (represented by the Dow Jones Select Dividend Index) lagged behind, with a median return of just 6.6%.”
While this may be an indication of bad news for the dividend- stock lovers out there, the question is why do growth stocks perform so well when rates rise? According to Tom O’Halloran, a Lord Abbett partner and director of multi-cap growth: “Their comparative advantage has improved because their costs have come down, the rapidly growing emerging markets now make up a larger share of their sales, and they’re in the midst of a productivity boom led by technology.”
Speak with your financial adviser to make sure your portfolio is ready for the new reality.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc., or its affiliates.
Aaron Katsman is a licensed financial professional in Israel and the United States who helps people with US investment accounts. He is the author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.