Pray for higher interest rates

OK. I know. I’m schizophrenic.  In my last post I’m telling you why I think interest rates will stay low longer than people expect. Now, I’m going to explain how rates could go higher and why I’m hoping they do. One of the things that makes investing a challenge is that you’re dealing with the future. As Yogi Bera so eloquently put, “It’s hard to make predictions, especially about the future”. The future, having many possible outcomes, is about dealing with probabilities. Most investors can’t deal with this. We’re emotionally wired with many biases that prevent us from effectively dealing with unkown outcomes. We crave certainty. With that in mind while I think the higher probability scenario is that interest rates stay low for a while I want to outline the scenarios for higher rates, some investments which would do well, and why this would be a positive outcome overall.

First, lets outline a few interest rate scenarios. All companies are exposed to changing interest rates even if they have zero debt. Interest rates impact cost of capital assumptions and the equity risk premium. But some companies are more exposed than others and need to plan for various interest rate outcomes. We can learn a lot as investors looking at how these professionals plan their business. The business models most exposed to changing interest rates are financial companies that lend money with long maturities and borrow money short term to fund that lending. They make money on the difference between long and short term interest rates. Banks obviously are the biggest users of this model. But the mortgage REITs (mREIT) are probably the most illustrative of this model and are very sensitive to changing interest rates. Lets look at how one mREIT, AGNC, thinks about various future interest rate scenarios. I’ll talk about mREIT details in another post but this is quite useful for today’s post.

AGNC is modeling three interest rate scenarios, two rising rate scenarios and one falling rate scenario. Their lowest probability scenario is one of rapidly rising rates. This is the one I want to highlight. They don’t think it will happen but they have a plan for it. And so should individual investors. The key here is why rates would rise quickly. You hear so many fear stories about when rates rise and no one talks about the most likely reasons for rising rates – economic growth rebounds quickly! Isn’t that what we want? Wouldn’t that be a good thing? This is the exact scenario I’m hopeful of. And if it does happen what are investment implications?

The most obvious response to rebounding economic growth that drives rates higher is higher stock prices. So, the best thing you can do to ‘protect’ yourself against rising rates is to have stock exposure. I always like dividend payers and even though they would probably under perform relative to growth stocks in this environment they would still go up. But what about bonds? There is an unmistakeable secular trend to income investments, in particular bonds, driven primarily by the aging baby boomer wave. Well, its easy to go back and look at bond returns in the worst rising rate environment in US history, the 70s and 80s. The chart below is from Vanguard and shows the performance of the US aggregate bond index (AGG) during that time.

Not as good as the massive returns from falling rates the last 20 years but not so dreadful as feared. Basically, over time interest income overcomes capital losses. What investors need to avoid is knee jerk reactions to rising rates (most will not avoid this). In the short term rising rates can cause large drawdowns in bond funds causing investors to sell near the bottom and not allowing enough time for the reinvestment of higher income to take effect. The whole Vanguard paper is worth reading. Also, as the paper points out it is critical to be exposed to multiple bond sectors during these times. Credit sensitive bonds sectors can do quite well during a rising rate environment. One of the main reasons for this is that credit spreads narrow during good economic times. Take a look at the credit spread before the financial crisis, chart below.

Credit spreads for investment grade and high yield bonds are about average now but back before the financial crisis they were much lower, in fact about 50% lower! And even better during a rising rate environment floating rate bonds will probably do the best. I plan a post on senior loan funds in the near future. They would do very well with rising rates. Bottom line with bonds in a rising rate environment is to make sure you’re in multiple sectors, not just government bonds. A good multi sector bond fund would be a conservative way to go. Aggressive investors can choose individual sectors themselves, like senior loan funds and even the aforementioned mREITs.

One last note is that when I say rising rates I mean a sustained increase in interest rates not short term fluctuations. In the short term rates can vary by quite a bit, in particular long rates, without indicating a change in the long term trend. Look at the 1 year chart of TLT, the long term bond ETF, below. TLT could go down to below 110 before even starting to indicate a change in the trend.

In summary, rising rates would be a good outcome because of what they indicate, and improving economy. Stocks would do best in such an environment and bonds will not do as bad as the conventional wisdom would have you believe in particular for those with a long term time frame. While not the most likely outcome given the macro environment I outlined in my last post it certainly should be part of your plan.

P.S. I don’t think its even worth addressing an often talked about scenario. I call it the Armageddon scenario. Hyper inflation, government default, doom and gloom, etc… I put no weight on that scenario. And besides you can read about it ad nauseum elsewhere.