After determining that the U.S. economy is expanding at a healthy pace, the Federal Reserve recently began raising rates up from what have been historic lows. Since the financial crisis in 2008, the Fed has raised rates three time, resulting in current rates sitting a full percentage point higher. Historically, the Fed has raised interest rates to reign in excessive economic growth and to contain inflation. Currently, the Fed’s goal is to normalize interest rates without negatively impacting growth. The Fed cited steady growth in the U.S. GDP, increasing jobs, very low unemployment, and a minor increase in inflation as reason for a rate hike. There is still uncertainty regarding how often rate changes will occur, but it is safe to say we have entered an environment of higher interest rates.
Changing interest rates can affect the performance of various investment assets. Outside of U.S. treasuries, short-term corporate bond performance improved greatly during periods of rate hikes. In each of the past five rate-hike episodes from 1986 through 2006, an index of one to three-year investment-grade corporate bonds outperformed both classes of U.S. treasury securities. The average return for those rate hike episodes was 3.29% versus 2.41% for 2-year treasuries and -1.87% for 10-year treasuries. Although we can’t predict the future based on the past, I do think it makes sense to be sure you are not in long term government bonds. I often see this in accounts that are being managed by investors themselves in Deferred Compensation plans. Investors don’t realize the interest rate risk they are taking on by having long term government bonds.
With high-yield bonds, the performance increase is even larger than corporate bonds. In every period besides June 1999-May 2000, the Bank of America Merrill Lynch High Yield Index outperformed the Barclays U.S. Aggregate Bond Index. The High Yield Index returned more than the two-year U.S. Treasury note during 3 out of 5 of the periods as well. Combining all five periods, the high-yield index returned an average of 3.84%, compared to 1.21% for the Barclays Aggregate Index and 2.42% for the two-year Treasury Index.
Increases in interest rates also affects the stock market. In the past four out of five rate hike periods, the S&P 500 Index outperformed a conservative investment strategy which invested in two-year Treasury notes. The only time the conservative strategy outperformed the S&P was in 1994 when the Fed raised rates in a surprise move. During the five periods, the S&P averaged a 13.71% return, compared to 2.41% for the two-year strategy. Rising rates are beneficial to bank stocks, since banks rely heavily on income generated by debt. Increases in fixed income and currency-trading revenue should help to boost financial companies higher. Compounded with talk of deregulating portions of the industry, the financial sector looks very healthy. On the other hand, utility stocks and stocks that are related to disposable income tend to not perform very well in high interest environments. In my opinion, investors may also want to look outside of the U.S. for growth opportunities. With global valuations lower than U.S. stocks, it’s likely foreign stocks could provide better return prospects.
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