While macroeconomic news out of China, and the price of oil has dominated the most recent financial market headlines, the U.S. Federal Reserve policy has been a subject of debate and intense focus for years.  Investors, bankers, economists and reporters alike are fixated on every word the Federal Reserve and its board of Governors releases.  The examination of, and some might argue obsession with, Fed statements has reached a point where the market can rapidly change direction based on just an alteration of word choice, even when the overall message remains the same.  These statements garner so much attention because traders and investors are trying to gain an edge in predicting when interest rates will rise.  Setting aside the debate on when the exact date of an interest rate hike might be, this paper examines what rising rates mean for your investment portfolio and argues that the long-term benefits are something investors should welcome not fear.  In order to examine this in detail, we first must have a good understanding of how the Federal Reserve works and why its policy affects interest rates.

What is the US Federal reserve and why does it matter?

The U.S. Federal Reserve Bank (commonly referred to as the Fed) is the central bank of the U.S. financial system and its primary function is to enact monetary policy that helps to stabilize and improve the U.S. economy.  The Fed’s three main objectives are: to maximize employment, keep prices of goods stable, and moderate long-term interest rates.  As the economy goes through cycles from economic booms to recessions, the Fed takes action to moderate the booms and minimize the probability and depth of recessions.  One of the key tools the Fed uses to keep the economy stable is interest rates. In this case, interest rates reflect the yield paid to buyers of U.S. Treasury bonds.  The Fed can influence the level of interest rates by buying large quantities of Treasury bonds on the open market, thereby pushing prices of the bonds up and yields down and vice versa.  In general, the Fed will increase interest rates in order to slow down the economy and decrease them to stimulate growth.

Why do investors fear rate increases?

Investors have feared the prospect of rising interest rates for two main reasons: the potential for slower economic growth and negative returns for bonds.  The Federal Reserve uses higher interest rates to slow the economy by increasing the cost of doing business and buying a house.  Companies looking to build a new factory or invest in new technologies often raise funds for these projects by issuing bonds.  As interest rates rise on Treasury bonds they rise correspondingly on corporate bonds, increasing the cost of financing for companies.  As the cost of financing increases, companies are less likely to invest in new projects, slowing the economic growth rate of the economy.  Similarly as interest rates rise on Treasury bonds, the interest rates for mortgages on homes also rise.  This increases the monthly payment required to build or own a home, subsequently slowing the pace of growth in the housing market.  While we think this is a legitimate concern in the long run because slowing economic growth can act as an impediment to earnings growth and stock prices, at this point in the interest rate cycle the effects should be limited.

Interest rate changes don’t just affect the economy; they can also have sudden and material impacts on performance of investment products.  Interest rates and the prices of bonds have an inverse relationship, as rates rise bond prices fall and vice versa.  During the past 30 years, investors have enjoyed a long cycle of declining interest rates.  In September of 1981 the 10-year Treasury Bond peaked at an interest rate of over 15%.  Since then, interest rates have been steadily declining, producing an environment of sustained strong performance as bond prices rise.  The U.S. Barclays Aggregate Index has delivered an annualized return of nearly 8% over that time span, with only a few short periods of mild negative returns, conditioning investors to expect strong consistent positive returns in fixed income.  Many fear that when the Fed changes its policy and begins to raise interest rates, negative bond returns will cause widespread selling of fixed income products causing further declines in bond prices.  This concern is certainly warranted and we have positioned our clients’ portfolios to protect against this risk, however, we continue to believe that higher interest rates is a healthy outcome for investors and the market in the long-run.

What are the benefits?

At Federal Street Advisors, we believe that rising interest rates do present real near-term risks that investors should be prepared for but recognize that higher interest rates will also bring long-term benefits to those who are well positioned.  Higher interest rates are an indication of economic strength, improve income available for investment products, and promote rational capital markets.

While the Federal Reserve does use higher interest rates to slow economic growth late in a business cycle, it is important to understand that the potential upcoming interest rate hike is not an attempt to slow growth but rather to return interest rates rate to a normalized level.  During the financial crisis of 2008/2009, the Federal Reserve lowered their interest rate policy target effectively to zero where it has remained since then.  This was a historically extreme measure designed to promote business investment, stabilize the housing market, restore confidence in the stock market and stimulate economic growth.  The Federal Funds target interest rate (the interest rate that the Fed targets for monetary policy) has been 0%-0.25% since December 16^th, 2008, well below its long run average of 7.4%¹.  An increase in the Fed’s target interest rate today would be indicative of their confidence in the economic strength and stability as they seek to bring interest rates to a normalized level, and not an attempt to slow the growth rate of the economy.

While a declining interest rate market has resulted in strong performance from bonds, low absolute levels of interest actually significantly reduce the potential for future returns.  One of the primary goals of a zero interest rate policy is to reduce the cost of financing for companies.  Companies have been able to issue bonds to investors at all-time low interest rates.  While this is a good deal for companies, it’s not a great outcome for investors, who are forced to take increasingly lower compensation for the risk of lending this money.  The yield on the Barclays U.S. Aggregate Index was just 2.3% as of September 30^th, compared to 6.6% twenty years ago.  Low coupon rates generally mean poor opportunities for returns and more recent results have reflected that as the Barclays Agg has returned just 1.7% in the last three years.  While an increase in interest rates will likely result in negative returns for bonds in the near-term, it greatly improves the long-term return potential by allowing investors to reinvest coupons at higher interest rates. In our estimation, investors in the Barclays U.S. Aggregate Bond Index might experience a drawdown of as much as 7.5% if interest rates were to rise by 2%, but would still be expected to achieve a 10-year annualized return 0.7% higher than a scenario in which interest rates remained unchanged and no drawdown occurred².  This scenario analysis highlights both the importance of protecting against the near-term risks of an interest rate increase but also the improvements to long-term total return opportunities.

Low interest rates can cause investors to take on more risk:

Sustained low interest rates also have significant impacts on investor behavior, which can cause imbalances in the capital markets.  Low interest rates means the retiring baby boomer generation in particular are not able to depend on the same level of income from their municipal bonds portfolios. Due to the lack of income in bonds, these investors have been forced to buy areas of the equity market that pay dividends, such as the utilities sector, but may expose themselves to more risk than is appropriate as a result. Increases in interest rates will bring increases in income from bond portfolios, and allow investors with lower risk profiles to return to more suitable asset allocations.

Pension funds will also benefit from a rising rate environment.  These funds are required to report an estimate of the value of their future obligations to pay benefits to retirees.  Since the bulk of these payments will occur in the future, they use a “discount rate” to calculate the value of the future payments in present terms.  This discount rate is tied to the prevailing interest rates in the market. Lower interest rates means a lower discount rate, which results in larger future obligations.  As interest rates fall, the pension fund’s financial health deteriorates and they are also forced to adopt a more aggressive or risky asset allocation to achieve the returns needed to pay retirees.  Conversely, if interest rates rise, pension funds should regain healthier financial conditions, the risk levels of their investments can be reduced, and payments to the beneficiaries will ultimately be more secure.

Active management will benefit:

Sustained low interest rates have also presented challenges to the performance of active managers through the encouragement of irrational investor behavior and unsustainable low financing costs.  While influencing the equity markets is not a stated goal of the Federal Reserve, it is an outcome of their zero interest rate policy.  As described previously, low income and poor total return expectations in bonds have pushed fixed income investors into buying stocks in the utilities sector.  In 2014, as interest rates fell, this sector returned 29%, outpacing every other sector in the market.  Active managers were broadly underweight the sector on fundamental concerns that high relative valuations and chronically low growth rates posed significantly greater risk than the promise of 3-4% of income.  In this environment, active managers posted one of the worst years of relative performance on record (link to previous paper here?).

In addition to changing investor behavior, low interest rates offer greater support to companies in poor financial condition making it more difficult to separate good investments from bad ones.  Low interest rates mean low financing costs for companies raising money through the issuance of bonds.  This low cost financing benefits companies in poor financial condition or those that have been mismanaged disproportionately to high quality, well-run business.  The best-run companies are typically rewarded with low financing costs in all market environments, or in many cases do not need to rely on debt financing at all because they are able to fund new projects and investment from cash flow from their existing business.  A decrease in interest rates has little effect on the cost structure of these companies. Conversely, when interest rates are low, low quality companies that need to raise cash from the debt markets are able to do so at lower costs than ever before.  The stocks of these low quality companies can be rewarded in low interest rate environments as their fundamentals appear improved, but as interest rates rise and the costs of financing increase, these results will be unsustainable.  While the style of active managers can vary, most look to buy companies with superior business models and strong management teams, which should benefit on a relative basis as interest rates rise leading to active manager outperformance.

Conclusion:

Given the attention the media gives the topic it is easy to get caught up in the intense debate of when the Fed might raise interest rates, but as recent history has shown it is difficult to predict.  In the beginning of 2014, 46 economists polled by the Wall Street Journal expected the Federal Funds rate to be an average of 1% by the end of 2015 and yet today the effective rate remains roughly 0.1%.  At Federal Street Advisors, we believe the game of attempting to time an unpredictable interest rate rise is not one that our clients will benefit from playing.  While we recognize that there are near-term risks to bond portfolios associated with an interest rate increase, it is increasingly important to keep the big picture in mind: a higher interest rate environment is both inevitable and healthy for the market, and investors who are well prepared will benefit.

¹“Historical Changes of the Target Federal Funds and Discount Rates.”  Federal Reserve Bank of New York, n.d. Web. 30 Oct. 2015. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

²Analysis assumes a parallel shift in the yield curve occurring evenly over the first 12 months with income being reinvested at higher rates. Full scenario analysis is available upon request.