Yields in the Treasuries market are at a three-decade low and the prospects of rising rates is mounting. For those worried about a rising rates environment, it may be time to shift a larger portion of assets away from fixed-income instruments and into equities-related exchange traded funds.
Typically, rates rise as a deterrent to an overheating economy, demand for credit increases and future inflation spikes, writes Daniel Morillo, Managing Director and Global Head of Investment Research for iShares. [Special Report: Navigating Higher Rates with Bond ETFs]
Consequently, fixed-income instruments will begin to fall out of favor since higher rates paid for newly issued debt makes the existing debt in circulation less attractive investments, especially for those with longer maturities. Additionally, the better economic conditions will push investors to the equities market, which reflects the higher expectations in earnings growth. [Treasury ETFs Suffer Worst Loss Since 2010]
“I believe this scenario is, by far, the most likely to play out in the medium term,” Morillo said on the iShares blog, “and it is certainly the scenario that has the most extensive historical precedent.”
“I would advocate some reallocation from fixed income to equities,” Morillo adviced for this type of market environment. “Looking at data since 1975, a reallocation in the 10-20% range appears to be a reasonable compromise between the increased risk to the portfolio from a larger holding of equities and the goal of protecting against the potential for raising rates.”
Morillo, though, cautions of two potential “tail risk” scenarios. In the event of a “policy error” where the Fed allows the economy to overheat, resulting in higher inflation expectations and long-term rates, we might experience a protracted inflation-fighting contraction – similar to what happened in the 1970s period of “stagflation.” Additionally, a “loss of confidence” scenario where creditors lose confidence in the government’s ability to pay back its deficits. Treasury Inflation-Protected Securities may be a better choice during a policy error or a shift to cash in the case of a loss of confidence, Morillo advises.
Even bond fund managers are warning about the dangers of rising interest rates. Bond rates and prices move in opposite directions.