What asset classes offer useful diversification in times of increasing interest rates?

14 Sep 2016

2016’s best performing asset class is without a doubt fixed-income. In fact, bonds have had a remarkable run over these past few decades: since 1973 United States’ treasury bills gained 7% p.a. and this with a volatility of merely 6% - implying a reward-to-volatility ratio of 1.2. In comparison: the historical reward-to-volatility ratio for the MSCI World is lower than 0.5. Yet, everything that has a beginning has an end...

Indeed, there are whispers that the improved fundamentals of the United States’ economy might convince Mrs. Yellen to raise the federal funds rate later on this year. In her speech at the global monetary policy conference the Chair stated that current forecasts imply a 70 percent probability that interest rates will be between 0% and 3.75% at the end of 2017. If interest rates would move towards the upper band of the predicted interval, fixed income instruments would go through a difficult time in the coming years.

So, what can bond investors do? What asset classes can offer useful diversification versus bonds in periods of sustained drawdowns? This is the question we will try to answer with the help of the table below:

First off, the old adage that bonds diversify equity risk is confirmed: the average quarterly return of bonds stood at 3.7% when equity markets went through their worst 10 quarters – falling on average with no less than 18.8%. Commodities did somewhat of a worse job, sometimes they provide huge diversification benefits for stocks (Q3 1974, Q3 1990), but sometimes they clearly aggravated an already very painful situation (Q3 and Q4 2008).

On to the matter at hand, it is clear that (government) bonds – whose worst quarterly return amounted to -6.4% - haven’t really had any steep drawdowns over these past 4 decades. Nevertheless, it does seem that when bonds are in the red both equities and commodities provide a decent hedge: over the 10 worst quarters in the government bond market both equities and commodities tended to rise in 70% of the cases and this on average by 3.3% and 4.3% per quarter. If you look at real returns (accounting for inflation) the relationship holds, although the hedge advantage somewhat shifts more towards the side of commodities.

In conclusion, it appears that while bonds clearly provide crisis alpha for stocks, equities do tend to return the favor when bonds go through a difficult time. It thus appears that you do not need to fear the upcoming rate hikes if you follow the number one investment wisdom: diversify your assets!