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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:
Senior Loans
Preferreds
Emerging Market Debt
High Yield Municipal Bonds
Mortgage-backed Securities
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
Dividend Growers
Mid-/Small-cap Stocks
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
Growth-sensitive Bonds:
Rate-sensitive Equities:
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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All asset allocation scenarios are for hypothetical purposes only and are not intended to represent a specific asset allocation strategy or recommend a particular allocation. Each investor's situation is unique and asset allocation decisions should be based on an investor's risk tolerance, time horizon and financial situation.
The educational information provided herein is not investment advice or a recommendation, and you should not rely on it as investment advice or a recommendation. You should consult with your tax and financial advisor prior to making any investment decision.
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No asset allocation model is a guarantee against loss of principal. There can be no assurance that an investment allocation determination using the information provided will be successful.
Risk associated with equity investing includes stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
Bond funds contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk.
There are additional risk for funds that invest in mortgage-backed and asset-backed securities including the risk of issuer default; credit risk and inflation risk.
The values of debt securities may decrease as a result of many factors, including, by way of example, general market fluctuations; increases in interest rates; actual or perceived inability or unwillingness of issuers, guarantors or liquidity providers to make scheduled principal or interest payments; illiquidity in debt securities markets; and prepayments of principal, which often must be reinvested in obligations paying interest at lower rates.
Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security's maturity date; liquidity risk which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal.
Investments in mortgage securities are subject to prepayment risk, which can limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment. The mortgage industry can also be significantly affected by regulatory changes, interest rate movements, home mortgage demand, refinancing activity, and residential delinquency trends.
Investments in Senior Loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a Senior Loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a Senior Loan will result in a reduction in the value of the Senior Loan and consequently a reduction in the value of the Portfolio’s investments and a potential decrease in the net asset value (“NAV”) of the Portfolio.
An actively managed fund may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.
A “value” style of investing emphasizes undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that the returns on “value” equity securities are less than returns on other styles of investing or the overall stock market. Although subject to the risks of common stocks, low volatility stocks are seen as having a lower risk profile than the overall markets. However, a fund that invests in low volatility stocks may not produce investment exposure that has lower variability to changes in such stocks’ price levels.