Positioning for a Higher Rate Reflationary Regime

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.

Based on this reflationary regime shift, five bond sectors may reduce the rate sensitivity and volatility of traditional bond allocations:

Senior Loans

• 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

Preferreds

• 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

Mortgage-backed Securities

• 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.

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

• 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

• 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-/Small-cap Stocks

• 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

Growth-sensitive Bonds:

• Senior Loans: SPDR® Blackstone Senior Loan ETF [SRLN]
• Preferreds: SPDR® Wells Fargo® Preferred Stock ETF [PSK]
• Emerging Market Debt: SPDR® Bloomberg Barclays Emerging Markets Local Bond ETF [EBND]
• High yield Municipal Bonds: SPDR® Nuveen Bloomberg Barclays High Yield Municipal Bond ETF [HYMB]
• Mortgages: SPDR® Portfolio Mortgage Backed Bond ETF [SPMB]

Rate-sensitive Equities:

• Value: SPDR® Portfolio S&P 500® Value ETF [SPYV]
• Dividend Growers: SPDR® S&P® Dividend ETF [SDY]
• Mid Caps: SPDR® Portfolio S&P 400^TM Mid Cap ETF [SPMD]
• Small Caps: SPDR® Portfolio S&P 600^TM Small Cap ETF [SPSM]