Over the past nine months, the Federal Reserve (Fed) has gradually reduced the pace of its asset purchases in conjunction with an improvement in the strength of the U.S. economy. With “tapering” expected to end October 29, we believe that investors should now look beyond 2014 and start to focus on when, not if, the Federal Reserve will raise the Federal Funds Rate. In our view, the way that investors have prepared their portfolios for tapering will be inadequate for the likely market reaction to increases in short-term rates. In this blog post, the first of a series on this topic, we focus on the performance of traditional fixed income and rising-rate alternatives as the Fed begins to shift policy.

Performance Review of Traditional Approaches to Rising Rates

When Fed Chairman Bernanke introduced the prospect of Federal Reserve tapering in May 2013, market pundits began to debate whether tapering was akin to a tightening of monetary policy. More than one year later, we can look back with the benefit of hindsight and conclude that tapering was in fact not tightening. However, as the market grappled with this question, we observed a meaningful test run for rising rate strategies that could prove useful when fears of tightening resurface. In the initial months following Bernanke’s comments, rates rose rapidly, catching many investors off-guard. When tapering didn’t occur as early as feared, short-term rates retraced while longer-term rates remained elevated. Unfortunately for investors, while most traditional approaches for reducing interest rate risk were able to generate positive returns, the magnitude of those returns paled in comparison to losses experienced in other parts of their bond portfolios.

As shown in the table, traditional approaches to rising rates during the “taper tantrum” managed only to avoid losses, as opposed to meaningfully contributing to portfolio returns. In our view, this poses a significant problem for asset allocators. When thinking about the role that fixed income has traditionally played in a balanced portfolio, these shorter-duration strategies provide very little income potential to dampen equity volatility. Fortunately for investors, equities continued to rally through the end of the year.

Shifting the focus of the analysis to the period of actual Fed tapering that began December 18, 2013, we see that traditional fixed income performed well as longer-term rates fell in 2014. Curiously, rising-rate strategies provided very similar returns to those experienced during the “taper tantrum.” This can largely be explained by the fairly muted rise in interest rates at the short end of the yield curve. During both periods, income potential was the primary driver of returns. As a result, total returns remained constrained but positive.

Tapering vs. Tightening