Given the growing disparities in outcomes for growth, inflation, and policies across the globe, we believe exposure to emerging markets fixed income can enhance yield and improve diversification as interest rates rise.
According to conventional wisdom, when US interest rates rise, US dollar-based investors should sell US Treasuries and move to equities and perhaps some non-US developed market bonds. But, our analysis shows this to be too simple – particularly since the US Federal Reserve (Fed) adopted unconventional monetary policies during the financial crisis of 2008-2009. We believe investors should consider the entire fixed income opportunity set, and select an investment manager equipped and prepared to actively navigate the environment. Given the growing disparities in outcomes for growth, inflation, and policies across the globe, we believe exposure to emerging markets fixed income can enhance yield and improve diversification – both of which may be beneficial as interest rates rise.
Once again, investor concern about higher interest rates is on the rise. And with that concern, many investors are rethinking the outlook for their bond portfolios. What should they consider? Diversification. And, since the introduction of unconventional monetary policy by the Fed in 2009, we believe this should not be limited to fixed income in developed markets, but should also include emerging markets.
For this exercise, we’ve chosen to consider the US 10-year Treasury rate, as opposed to the federal funds rate, as we believe that market interest rates can anticipate or lag actions of the Fed and are therefore more pertinent when examining the effects of rising interest rates on other financial assets. This has been especially true recently, as the market has frequently anticipated Fed moves – and pushed US Treasury rates significantly higher – even when the Fed did nothing. Moreover, US 10-year Treasury rates are more-representative of the underlying cost of funding for issuers in the US dollar bond market.
Over the past 25 years, nine periods can be identified in which US interest rates were rising (table1)1.
Table 1 - Periods of rising US interest rates
1/94 - 11/94
1/96 - 6/96
10/98 - 1/00
6/05 - 6/06
12/08 - 6/09
10/10 - 2/11
5/13 - 3/13
1/15 - 6/15
7/16 - 12/16
|10-yr US Treasury (change in yield, in basis points)||239||154||263||136||189||135||137||84||124|
|US Treasury Index||-5.94||-4.09||-4.57||-2.16||-6.99||-4.64||-4.52||-3.29||-5.67|
|Barclays Global Treasury Index||-5.34||0.43||0.01||0.46||-2.34||-3.63||-3.48||-3.19||-4.12|
|S&P 500 Index||-3.85||10.00||46.23||3.64||5.45||14.38||3.60||5.52||6.20|
|MSCI World Index||-1.22||6.22||52.02||10.84||7.81||11.69||1.90||5.91||5.55|
Total returns in USD. US Treasury Index: Bloomberg Barclays US Treasury Index; Barclays Global Treasury: Bloomberg Barclays Global Aggregate Index. Source: Bloomberg L.P., as at 31 December 2016.
We define a period of rising rates as one in which the rate on the US 10-year US Treasury rose by 100 basis points or more, although we also include the first half of 2015 when rates rose by only 84 basis
As seen in table 1, over the past 25 years, fixed income assets performed relatively poorly during periods of rising rates, while equities performed well. Indeed, in every period of rising rates, US Treasuries posted negative total returns, while the Standard and Poor’s 500 equity index posted a gain in all but one period. This history is likely behind investors’ general impression that fixed income assets should be sold and equities bought in periods of rising rates.
However, as we will show, things are not that simple. Outcomes across the fixed income spectrum can vary widely depending on both the risk attributes of the asset class and the economic and policy landscape in which interest rates are rising. Of particular importance is the regime shift in Fed policy that occurred in 2009. Figure 1 provides an overview.
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1 Periods of rising rates we identified are 1: 31/01/1994-07/11/1994, 2: 18/01/1996- 12/06/1996, 3: 05/10/1998-20/01/2000, 4: 01/06/2005-28/06/2006, 5: 31/12/2008- 08/02/2009, 6: 07/10/2010-08/02/2011, 7: 02/05/2013-05/09/2013, 8: 30/01/2015-10/06/2015, 9: 08/07/2016-15/12/2016.