Fueled by accommodative monetary policies and additional fiscal stimulus, higher inflation expectations and upbeat growth prospects continue to put upward pressure on interest rates. Going forward, a higher rate reflationary regime could upend what has worked in the standard 60/40 portfolio over the past decade (long-duration bonds and growth stocks).
To ensure portfolios remain properly diversified and meet their return objectives, investors could consider replacing traditional bonds and growth stocks with growth-sensitive bonds and rate-sensitive stocks in the portfolio’s core.
Target growth-sensitive bonds As rates have moved higher in 2021, the higher yield has not offset the duration-induced price losses; broad core aggregate bonds are down 3% so far this year.1 Yields also remain suppressed both relative to long-term averages (66% below 30-year average)2 and when compared to inflationary expectations. The 1.53% yield for core aggregate bonds (Agg),3 compared to five-year inflationary expectations of 2.36%4 indicates the potential for a negative real return from the coupon alone.
With rates well off their pandemic lows and increasing by 40 basis points so far this year, it is fair to say rates have bottomed out. Yet the expected returns on core aggregate bonds remain low and are likely to be below what investors have witnessed over the past decade, given there is a 93%5 correlation of the yield at time of purchase and the subsequent three-year annualized total returns, as shown below. Current yields are just 1.53%, so returns over the next three years could be around that level if the historical trend remains intact.
Source: Bloomberg Finance L.P., as of March 17, 2021. Past performance is not a guarantee of future results
Based on this reflationary regime shift, five bond sectors may reduce the rate sensitivity and volatility of traditional bond allocations:
For a credit allocation, loans have a relatively similar yield to fixed rate high yield debt at 3.7% versus 4.2%,6 but are more senior in the capital structure and historically have witnessed lower relative levels of volatility (5.8% versus 7.7%).7
Like other credit exposures, loans may continue to benefit from the ongoing loose monetary and fiscal policies that have supported risk assets over the past few months. Amid the reflation rally, loans have outperformed the broader Agg for 11 consecutive months.8
Loans’ floating rate component means rising rates may not negatively impact total return as much as they could for fixed rate high yield. Curve change effects subtracted 142 basis points of return for fixed rate high yield thus far this year,9 but had a negligible impact on loans.10
While offering a yield 3.3 and 1.3 times higher than that of the Agg and high yield bonds, respectively, preferreds hold primarily investment-grade rated securities.11
As a hybrid with balanced equity and bond correlations (56% and 43%, respectively), preferreds may also offer a diversified income stream significantly lower than high yield’s 77% correlation to equities.12
Preferreds’ lower volatility than both high yield and equities (6.9% versus 7.7% and 14.9%)13 leads to more attractive yield per unit of volatility measures.
Emerging Market Debt
Emerging market local debt (EMD) offers a noticeable yield advantage (3.77%) over traditional core US Agg bonds (1.53%).14
With 85% of issues rated above BBB,15 EMD is still considered investment grade but has just a 32% correlation to the rate-sensitive Agg.16
The risk profile of EMD offers potential diversification benefits to bond portfolios that might currently rely solely on credit and rate risks to generate income, as currency trends play a significant role in the risk and return of EMD — evidenced by a historical 93% correlation between EM local debt and EM local currency returns.17
High Yield Municipal Bonds
High yield municipal bonds yield more than traditional corporate high yield bonds on an after-tax basis. The current yield to worst on high yield municipal bonds is 3.17%18 while high yield corporates yield 4.2% pre-tax, but 2.70% post-tax.19
Income from high yield municipals is generated with lower volatility than high yield corporates (6.4% versus 7.2%)20 and the $300 billion dedicated to shoring up state and local balance sheets from the $1.9 trillion pandemic relief bill may alleviate any concerns of increased default risk
High yield municipals are less correlated to equities than corporate investment grade and high yield bonds (21% versus 48% and 77%, respectively),21 leading to a potential source of higher income generation without additional equity risk. High yield municipals are also less correlated to traditional core Agg bonds than US IG corporates are (52% versus 80%).22
With a different rate risk profile (3.57 years duration) than other core bond sectors (US Treasuries 6.88 years, US IG Corporate Bonds 8.5 years), mortgage-backed securities (MBS) may be a valuable overweight in the core.23
MBS offer a yield (1.78%) above that of core Aggregate bonds (1.53%) and US Treasuries (0.93%) with lower volatility (2% versus 3% and 4%, respectively).24
Two favorable market trends — the strong housing market25 and the Federal Reserve continuing to purchase MBS ($40 billion a month) as part of its stimulus plan — may temper extension risk fears from higher rates.
Focus on rate-sensitive stocks Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flow. The duration term is rarely used for equities — yet it is applicable.
For growth stocks, there are expectations for higher growth/cash flows further out in the future, much like a bond with a long-term maturity payment. Given the potential for growth stocks to generate higher cash flows in the future, they can be considered “long-duration” equities. And, like long-duration bonds, they are more adversely impacted by a rise in rates. Interest rates affect the discount rate used when calculating the net present value of those cash flows. Higher interest rates will increase the discount rate and lower growth stocks’ net present value — impacting already elevated valuations, which currently appear stretched.26
Value stocks, however — as a much shorter duration equity style — have historically tended to have a more positive relationship to interest rate movements than growth stocks. In fact, value stocks have a more than 55% correlation to rates compared to just 27% and 34% for growth stocks and the broader market, respectively.27 And currently, the correlation would indicate that rising inflation and growth expectations have pushed interest rates higher – leading to a rotation out of growth and into value, where relative valuations are in the bottom decile across price-to-next-twelve-month-earnings ratio, price-to-book ratio, and price-to-sales ratio compared to top decile for growth stocks.28
There is plenty of momentum behind this rotation. Value’s February excess return relative to growth was the strongest return differential since 2001 and was a two-standard-deviation event. As a result, value’s rolling three-month excess return to growth is in the 93rd percentile since 1995.29 In fact, value’s rolling three-month excess return to growth has been positive for more than 70 consecutive days — the longest stretch since 2016.
Unlike in 2016, however, there has been a major decoupling of stock and bond correlations. While both the broader market and growth stocks have become more correlated with bonds — rising well above their long-term median of -25% and -23%, respectively30 — value stocks have decoupled from the other two equity barometers’ trend, as shown below. Although likely to mean-revert in time, this signifies a regime shift in the markets. Therefore, as the recovery progresses, cyclical/value equities may offer ballast from the impact of rising rates on bond portfolios.
Source: Bloomberg Finance L.P., as of February 25, 2021. Past performance is not a guarantee of future results.
Note, however, that ultra-short duration/bond proxies (Utilities, REITs) may be negatively impacted by higher rates due to their embedded financing debts (i.e., high debt levels on balance sheets). Based on the near-positive return correlation between bonds and broad-based equities after a rise in rates, investors may want to consider the below three equity options to increase the rate sensitivity of their stock allocations to temper the effects of higher rates while reducing the correlation between the two broad asset categories (stocks and bonds).
Value has become less correlated to bonds, as shown above.
Value’s correlation and beta profile (55%/0.30) to rates is higher than both the market and growth disciplines (34%/0.12 and 27%/0.11, respectively)31
Constructive valuations and expected 2021 earnings-per-share growth (25%) above that of growth styles (20%) and the market (24%) indicate a cheaper source of growth32
Dividend growers’ current dividend yield is higher than core bonds (3.23% versus 1.53%).33
Value oriented and more sensitive to rate movements than the market, dividend growers’ correlation/beta metrics to rates is 42%/0.14.34
Dividend growers have outperformed the broader market by 5.3% since the start of November when the reflation rally took shape following the removal of dual headwinds (election and vaccine timeline uncertainty).
Mid caps and small caps have higher rate sensitivity than large caps (0.20/0.25 versus 0.12 beta)35
Relative valuations for both asset classes are attractive as their price-to-next-twelve-month-earnings ratio, price-to-book ratio, and price-to-sales ratio are in the bottom decile relative to the S&P 500.36
Higher expected growth (46% for mid caps and 57% for small caps) versus large caps (24%) over the next year37 indicates a cheaper source of growth versus traditional core styles.
Looking ahead In addition to the $1.9 trillion fiscal stimulus and the Fed’s continued accommodative monetary policies, the US personal savings rate — currently 20% of disposable income and $1.7 trillion more than the pre-pandemic rate38 — signals pent-up spending that could be unleashed as the economy reopens. By ushering in higher growth and inflation, this could push rates even higher and have an impact throughout asset allocation models as the markets navigate this latest regime shift.
To meet return targets in a rising rate and reflation regime, the standard 60/40 portfolio needs to be tailored — both in and outside of the core.
SPDR® ETFs for the Higher Rate Reflationary Regime
Mid Caps: SPDR® Portfolio S&P 400TM Mid Cap ETF [SPMD]
Small Caps: SPDR® Portfolio S&P 600TM Small Cap ETF [SPSM]
1Bloomberg Finance L.P., as of February 26, 2021, based on the total return of the Bloomberg Barclays US Aggregate Bond Index. 2Bloomberg Finance L.P., as of February 26, 2021, based on the yield-to-worst of the Bloomberg Barclays US Aggregate Bond Index from February 1991 to February 2021. 3Bloomberg Finance L.P., as of February 26, 2021, based on the yield-to-worst of the Bloomberg Barclays US Aggregate Bond Index. 4Bloomberg Finance L.P., as of February 26, 2021, based on the US 5-year breakeven rate. 5Bloomberg Finance L.P., as of February 26, 2021, calculations by SPDR Americas Research by calculating the long-term correlation of the yield and return stream for the following three-year period. 6Bloomberg Finance L.P., as of February 26, 2021, based on the yield-to-worst for the S&P/LSTA Leverage Loan 100 Index and the Bloomberg Barclays US Corporate High Yield Bond Index. 7Bloomberg Finance L.P., as of February 26, 2021, based on the returns for the S&P/LSTA Leverage Loan Index and the Bloomberg Barclays US Corporate High Yield Bond Index over the prior 60 months. 8Bloomberg Finance L.P., as of February 26, 2021, based on the returns for the S&P/LSTA Leverage Loan Index and the Bloomberg Barclays US Aggregate Bond Index. 9Bloomberg Finance L.P., as of February 26, 2021, based on the returns for the Bloomberg Barclays US Corporate High Yield Bond Index in 2021 utilizing an excess return spread Bloomberg attribution model. 10Bloomberg Finance L.P., as of February 26, 2021, based on the returns for the S&P/LSTA Leverage Loan Index utilizing an excess return spread Bloomberg attribution model. 11Bloomberg Finance L.P., as of February 26, 2021, for the Bloomberg Barclays US Corporate High Yield Bond Index (4.2%), Bloomberg Barclays US Aggregate Bond Index (1.53%), and the yield-to-maturity for the ICE BofA Hybrid Preferred Securities Index (5.01%). 12Bloomberg Finance L.P., as of February 26, 2021, for the monthly returns from February 2016 – February 2021 for the Bloomberg Barclays US Corporate High Yield Bond Index and the ICE BofA Hybrid Preferred Securities Index relative to the S&P 500 Index and Bloomberg Barclays US Aggregate Bond Index. 13Bloomberg Finance L.P., as of February 26, 2021, for the standard deviation of monthly returns from February 2016 – February 2021 for the Bloomberg Barclays US Corporate High Yield Bond Index and the ICE BofA Hybrid Preferred Securities Index relative to the S&P 500 Index. 14Bloomberg Finance L.P., as of February 26, 2021, based on the Bloomberg Barclays EM Local Currency Government Diversified Index. 15Bloomberg Finance L.P., as of February 26, 2021, based on the Bloomberg Barclays EM Local Currency Government Diversified Index. 16Bloomberg Finance L.P., as of February 26, 2021, based on the Bloomberg Barclays EM Local Currency Government Diversified Index monthly returns from February 2016 – February 2021. 17Bloomberg Finance L.P., as of February 26, 2021, based on monthly returns between the Bloomberg Barclays EM Local Currency Government Diversified Index and the MSCI EM Local Currency Index from February 2011 to February 2021. 18Bloomberg Finance L.P., as of February 26, 2021, for the Bloomberg Barclays Municipal Yield Index. 19Bloomberg Finance L.P., as of February 26, 2021, for the Bloomberg Barclays US Corporate High Yield Bond Index. After-tax yield is based on the yield-to-worst and applying the highest marginal federal income tax rate of 37%. This may differ for actual investors based on their tax bracket and it is meant to be an illustration of the impact on taxes in such a low-rate environment. It does not account for state taxes or net investment income taxes. Actual results may differ. 20Bloomberg Finance L.P., as of February 26, 2021, for the standard deviation of monthly returns from February 2016 – February 2021 for the Bloomberg Barclays US Corporate High Yield Bond Index and the Bloomberg Barclays Municipal Yield Index. 21Bloomberg Finance L.P., as of February 26, 2021, for the monthly returns from February 2016 – February 2021 for the Bloomberg Barclays Municipal Yield Index, the Bloomberg US Corporate Bond Index, and the Bloomberg Barclays US Corporate High Yield Bond Index versus the S&P 500 Index. 22Bloomberg Finance L.P., as of February 26, 2021, for the monthly returns from February 2016 – February 2021 for the Bloomberg Barclays Municipal Yield Index, the Bloomberg US Corporate Bond Index versus the Bloomberg Barclays US Aggregate Bond Index. 23Bloomberg Finance L.P., as of February 26, 2021, for the Bloomberg Barclays US MBS Index, the Bloomberg US Treasury Index and the Bloomberg Barclays US Corporate Bond Index. 24Bloomberg Finance L.P., as of February 26, 2021, for the monthly returns from February 2016 – February 2021 for the Bloomberg Barclays US MBS Index, the Bloomberg US Treasury Index versus the Bloomberg Barclays US Aggregate Bond Index. 25“Improvement in U.S. Homebuilder Sentiment Belies Cost Concerns,” Bloomberg, February 17, 2021. 26FactSet, as of February 26, 2021. Price-to-next-twelve-month-earnings ratio, price-to-book ratio, and price-to-sales ratio for S&P 500 growth stocks are in the 90th percentile relative to their own history in the past 15 years. 27Bloomberg Finance L.P., as of February 26, 2021, based on the monthly returns of the S&P 500 Pure Value Index, S&P 500 Pure Growth Index, and S&P 500 Index versus the US 10-year yield from February 2016 to February 2021. 28FactSet, as of February 26, 2021. Price-to-next-twelve-month-earnings ratio, price-to-book ratio, and price-to-sales ratio for S&P 500 value stocks are below the 10th percentile relative to the S&P 500 Index over the past 15 years. 29Bloomberg Finance L.P., as of February 26, 2021, based on the return between the S&P 500 Pure Value Index and the S&P 500 Pure Growth Index. 30Bloomberg Finance L.P., as of February 26, 2021, based on the daily returns of the S&P 500 Pure Value Index, the S&P 500 Pure Growth Index, the S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index. 31Bloomberg Finance L.P., as of February 26, 2021, based on the monthly returns of the S&P 500 Pure Value Index, S&P 500 Pure Growth Index, and S&P 500 Index versus the US 10-year yield from February 2016 to February 2021. 32FactSet, as of February 26, 2021, based on the S&P 500 Pure Value Index, the S&P 500 Pure Growth Index, and the S&P 500 Index based on consensus analyst estimates. 33February 26, 2021, based on the trailing 12-month dividend yield for the S&P High Yield Dividend Aristocrats Index and the Bloomberg Barclays US Aggregate Bond Index yield-to-worst. 34Bloomberg Finance L.P., as of February 26, 2021, based on the monthly returns of the S&P High Yield Dividend Aristocrats Index versus the US 10-year yield from February 2016 to February 2021. 35Bloomberg Finance L.P., as of February 26, 2021, based on the monthly returns of the S&P 400 Mid Cap Index and the S&P 600 Small Cap Index versus the US 10-year yield from February 2016 to February 2021. 36FactSet, as of February 26, 2021, based on the S&P 400 Mid Cap Index and the S&P 600 Small Cap Index. 37FactSet, as of February 26, 2021, based on the S&P 400 Mid Cap Index, the S&P 600 Small Cap Index, and the S&P 500 Index based on consensus analyst estimates. 38“U.S. Insight: The Hidden Stimulus Priming a GDP Rebound,” Bloomberg, March 2, 2021.
Earnings Per Share (EPS) A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
Price-to-Book Ratio, or P/B Ratio A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). A high P/B means either that investors have overvalued the company, or that its accountants have undervalued it.
Price-to-Earnings Share price divided by earnings per share. Lower numbers indicate an ability to access greater amounts of earnings per dollar invested. A higher number indicates that a company’s stock is overvalued.
Price-to-Sales Share price divided by per share revenue.
Standard Deviation A statistical measure of volatility that quantifies the historical dispersion of a security, fund or index around an average. Investors use standard deviation to measure expected risk or volatility, and a higher standard deviation means the security has tended to show higher volatility or price swings in the past. As an example, for a normally distributed return series, about two-thirds of the time returns will be within 1 standard deviation of the average return.
Yield Curve A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be “flat,” it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be “steep,” it means the difference in yields between bonds with shorter and longer durations is relatively wide.
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