So, should you avoid adding to your equity holdings if you’re concerned about rising rates? Not quite, since the larger average excess return of equities can dampen the impact of low or negative bond returns when rates rise. The upshot is that investors who are concerned about rising rates can benefit from a larger equity allocation as equities are diversifying to bonds and historically, their larger average return has provided an offset to poor bond returns when rates rise. Of course, there is no free lunch, as the potential cost of a larger equity position is that equities are riskier than bonds and thus a larger equity position is effectively a tradeoff between lower to the effect of rising rates at the cost of higher overall risk.
To illustrate the nature of this risk tradeoff, let’s use the DMS data and consider the 10-year period between 1972 and 1981, (from the breakup of the gold standard to the rate peak). Over this decade, short-term rates almost quadrupled from under 4% to close to 15%. A conservative portfolio composed of 70% bonds and 30% equities would have shown average annual excess returns of negative 2.5%, according to the DMS data. On the other hand, a portfolio with more aggressive positioning of 70% equities and 30% bonds would have shown average annual excess returns very close to zero, a better outcome by comparison. However, the DMS data shows the additional risk associated with the equity-heavy portfolio was significant. Given the annualized risk of over 20% for equities during that period, compared with about 7% for bonds, even after 10 years there was a reasonably high chance (1 in 4) of underperforming the bond-heavy portfolio notwithstanding the higher average excess returns from equities.
Daniel Morillo, PhD, is the iShares Head of Investment Research.
[1] The analysis in this post is done with returns measured in excess of the return associated with short-term bonds generally described as the “risk free” rate. This is because I have an interest in the tradeoff between taking bond risk (i.e. risk associated with holding longer-term bonds) and equity risk in order to obtain returns beyond what is possible via simply investing in short-term government securities.
[2] Data is from Bloomberg. Bond returns are computed as the return in the Barclays 7-10 year bond index minus the 1-month Treasury bill rate. Equity returns are computed as the returns of the S&P 500 total return index and the 1-month Treasury bill rate. Data on Treasury bill rates is from the standard H15 release from the FED.
[3] The DMS data is collected by Dimson, Marsh and Staunton as described in “101 years of global investment returns” (2002) and updated annually. For bond returns I use nominal long-term government bond (i.e. “treasuries”) total return for each country in excess of the nominal short-term bond return (i.e. the “risk-free” or “bill” rate) for that country. For equity returns we use nominal equity total returns in excess of the nominal short-term bill return.
[4] We have used 1972 as the first year of returns for this sample given that the U.S. exited the Bretton Woods system in August 1971.