4 Ways to Position Portfolios for Rate and Macro Risks

The standard 60/40 portfolio is on track to rebound from last year’s loss, its worst since the Great Financial Crisis. Yet, with stocks stumbling in August and core bonds declining for the fourth consecutive month, globally diversified portfolios may face challenges through year-end.

Current headwinds include stretched valuations, higher-for-longer speak from global central banks, political theatrics surrounding US budget deadlines, and the start of a third quarter earnings season where the bar already has been raised.

But investors shouldn’t rush to the sidelines in fear. As the saying goes “Scared money don’t make no money.” Here are four ideas to consider as you position portfolios amid evolving interest rate and macro risks.

Don’t Fight the Fed: Take 5% from Ultra-short Bonds

To curb inflation, the Federal Reserve (Fed) has persistently raised rates over the past 18 months. And although the Fed left its benchmark interest rate unchanged at a 22-year high at September’s meeting, Chairman Powell indicated that rates will remain higher for longer because “the process of getting inflation sustainably down to 2% has a long way to go.”¹

With the economy growing faster than the Fed thought — GDP was revised upward from 1.1 to 1.5% — median forecasts now see one more rate hike before the end of the year.² And rate cuts aren’t forecast to begin until late spring 2024 (Figure 1).  

This rhetoric likely will keep short-term market rates (i.e., Treasury-bills) elevated. US 1-3 month Treasury bills (T-bills) have historically tracked the fed funds rate, given their ultra-short and cash-like nature (Figure 2). If this relationship holds, this ultra-short duration segment of only 0.14 years could see its current 22-year high yield increase alongside policymakers’ actions.³

So don’t fight the Fed. For both income potential and capital preservation, just take the yield offered on rates most connected to Fed policy.

Take the greater than 5.00% yield offered on below one-year maturities on the curve (the only portion above 5.00%). The 5.46% yield on 3-month T-bills exceeds the 4.54% cash earnings yield on stocks by the widest level since 2001 (92 basis points).⁴

That T-bill yield also comes with asset volatility that is 97% and 90% lower than stocks and bonds, respectively.⁵ And T-bills also have outperformed core bonds for the past two years and so far in 2023 as a result of this rate environment.⁶

For income generation and capital preservation, focus on the ultra-short tenors of the yield curve that yield more than 5% with the SPDR® Bloomberg 1-3 Month T-Bill ETF (BIL) or the SPDR® Bloomberg 3-12 Month T-Bill ETF (BILS).

In addition, an active ultra-short-duration strategy can access other attractive ultra-short bond segments such as securitized credits, asset-backed securities, mortgage-backed securities, and commercial mortgage-backed securities. To broaden exposure in the ultra-short sector beyond T-Bills, the actively managed SPDR® SSGA Ultra Short Term Bond ETF (ULST) targets a duration of one year or less and invests at least 80% of its net assets in a diversified portfolio of US dollar-denominated investment-grade fixed income securities, including up to 10% in high yield.

Choose Quality and Value for a Smoother Ride in the Core

Seasonality trends don’t indicate much of a respite from the latest bout of choppy markets, at least not initially. Dating back to 1956, September has proven to be the weakest returning month on the calendar.⁷ October ranks as the sixth-worst, or middle of the pack. These trends align with how average CBOE VIX Index readings for these two months rank as the first- and second-highest since 1989.⁸

Any political theatrics surrounding a potential US budget impasse and government shutdown could exacerbate this seasonal volatility.⁹ At the same time, however, fundamental trends remain mostly positive.

There have been more upside than downside revisions to full-year 2023 earnings for large and small caps over the past three months (Figure 3). And fewer mentions of recession during earnings calls illustrate how recession fears have abated.¹⁰ But those upgrades have raised the earnings bar higher for firms for the third quarter.

The Q3 bottom-up earnings-per-share (EPS) estimate increased by 0.3% from the end of Q2 through the end of August,¹¹ when typically analysts reduce earnings estimates during the first two months of a quarter. During the past ten years, the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 2.7%.¹²

If firms can’t beat these increased expectations, losses could accumulate and sentiment would be restrained. Notably, firms that missed earnings in Q2 witnessed a -2.6% decline over the next two days compared to the average -2.2% decline.¹³

Heightened macro risks, a higher hurdle rate, and stretched valuations mean the path ahead may be a bit bumpy. But, de-risking completely by using a single factor Low Volatility strategy to control volatility may not be the best approach given earnings sentiment (upgrade-to-downgrades) is trending positive. In fact, adopting a full de-risking mindset this year would have led to below market returns (3.8% versus 17.3%), as that single factor can limit upside.¹⁴

Using a strategy with an imbedded factor bias toward Low Volatility, but with sufficient upside capture due to a mix of return-seeking factors like Quality and Value, may be one way to lower the risk of staying invested. And this mix of Low Volatility, Quality, and Value factors (Factor Mix) has not been impacted by cyclical market shifts as much as some single factors have been (Figure 4).

If you’re looking for a strategy that blends diversifying factors to seek a smoother ride in the core of equity portfolios, consider the SPDR® MSCI USA StrategicFactors℠ ETF (QUS) and the SPDR® MSCI EAFE StrategicFactors℠ ETF (QEFA).

These funds seek to mitigate downside risk while retaining upside potential by combining three factors: a factor to de-risk (Low Volatility) and two return-seeking factors with offsetting business cycle tendencies (Value and Quality).

Get Active in Your Bond Core

Credit spreads are tight and rate volatility is elevated. Both investment-grade and high yield credit spreads have narrowed this year, and high yield spreads sit 25% below their historical average (Figure 5). A tight credit spread environment indicates that valuations for taking on credit risk alone aren’t overly conducive on a forward-looking return basis.

High yield bonds’ effective convexity, which has fallen all year and is now nearly negative,¹⁵ also supports the idea that there is less upside relative to downside. Yet, credit can’t be ignored.

The current elevated yield environment, where high yield bonds yield over 8.5% and investment-grade credit close to 6%, has led to positive total returns this year as a result of the coupon return.¹⁶ That’s stronger performance than the traditional Bloomberg US Aggregate Bond Index (Agg).

Rate volatility is also elevated. The ICE BofA MOVE Index, which measures implied volatility based on options pricing, is in the 88^th percentile over the past ten years and hasn’t dropped below the 80^th percentile since the start of 2022.¹⁷

Realized volatility is also elevated; the Agg’s rolling 90-day realized standard deviation of returns is in the 83^rd percentile over the past decade and also hasn’t dipped below the 80^th percentile since January 2022.¹⁸

Credit valuations and rate risks mean using active bond strategies in the core may help investors pursue attractive income opportunities while balancing credit and macro risks. By tailoring duration and using active sector allocation and security selection, an active core bond strategy may outflank the risks core bonds face in the current environment.

The actively managed SPDR® DoubleLine® Total Return Tactical ETF (TOTL) combines traditional and non-traditional fixed income asset classes like high yield, bank loans, and emerging market debt to maximize total return over a full market cycle. And the fund’s embedded mortgage bias enhances its credit quality, as these securities are backed by the federal government. While the fund does have below-investment grade exposure, 74% is allocated to investment-grade rated debt and 58% of total holdings are rated AAA.¹⁹

Investors who are looking to sharply trim duration (a risk factor) in the core and infuse return streams with more stability, while also maintaining broad sector exposure and the potential for alpha generation, may want to consider the short-term version of TOTL. The SPDR® DoubleLine® Short Duration Total Return Tactical ETF (STOT) employs a similar approach to TOTL, but seeks to maintain a dollar weighted average effective duration between one and three years.

Can Hybrids Reduce Volatility and Boost Returns?

In an environment of evolving macro risks and cautiously optimistic fundamental trends, many investors seek to reduce portfolio volatility while maintaining exposure to stocks and bonds for their return and income potential. Hybrid exposures that offer a mix of stock- and bond-like characteristics may be a helpful solution.

Convertible securities are corporate bonds with an embedded option that allows investors to
convert bonds into the common stock of the issuing company. As a result, they combine the upside potential of equities with a coupon payment and bond-like floor to assist in mitigating downside risk. Convertibles’ correlation to stocks and bonds is 0.88 and 0.31, respectively.²⁰

Convertible issuers tend to be more common in high growth sectors; more than 50% of the convertibles market is allocated to the Consumer Discretionary, Communication Services, and Information Technology sectors — the three sectors powering equity returns this year. This structure has led convertibles to post stronger returns than bonds this year (9.00% versus 0.22%),²¹ with 30% less volatility in returns than stocks.²²

Despite the return trends, convertibles’ valuations indicate they’re now trading more like bonds than stocks. Convertibles’ low sensitivity to the underlying stocks is also met with a higher-than-average premium to parity, which is the difference between the price of convertibles and the value of the underlying equity if converted (Figure 6).

Overall, convertible securities may offer risk-controlled equity exposure with the potential for upside growth — but with less volatility than straight equities. Combining an allocation to convertibles with preferred securities, another type of hybrid investment, introduces an income overlay alongside sector diversification but with equally balanced correlation profiles (0.55 to stocks and 0.60 to bonds). ²³

While convertibles yield roughly 5.0%, preferreds yield 6.8%.²⁴ A 50/50 blend of the two would produce a yield of near 5.9% — that’s 74 basis points greater than the yield on the Agg, 373 basis points more than global stocks, and more than the standard globally diversified 60/40 portfolio.²⁵

This hybrid blend’s yield potential coincides with a historical volatility profile below that of stocks and on par with the standard 60/40 portfolio (Figure 7) over the last decade. And, additional volatility/correlation data illustrate the historical differentiated nature of this blend.

The market’s positive returns so far this year are now being met with some near-term risks. Consequently, a blend of convertibles and preferreds may be a useful low volatility strategy to efficiently allocate capital on both sides of a balanced portfolio, while also enhancing yield relative to core stocks and bonds.

To access the convertibles market, consider the SPDR® Bloomberg Convertible Securities ETF (CWB).

To access the preferreds market, consider the SPDR® ICE Preferred Securities ETF (PSK).

For more timely insights on market trends and portfolio positioning, don’t miss this month’s Chart Pack.