To Shift Or Not To Shift: Understanding The Consequences Of Hedging Market Risks

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by: Nanette Abuhoff Jacobson


Investors concerned about rising interest rates or a sell-off in equities have shifted their allocations to offset these risks. But might they be trading one type of risk for another?

How does credit perform when rates fall?

How do income-oriented stocks perform in a rising rate environment?

How does moving into these kinds of assets at the same time impact portfolios?

Investors have recently been concerned about two key risks: rising interest rates and a sell-off in equities. To address these worries, many have pursued one or both of the following rebalancing strategies: Within fixed income, moving out of core assets and into less interest-rate-sensitive, credit-oriented assets; and within equities, moving out of equities and into less volatile stocks, particularly dividend payers.

On the surface, these recommendations seem sound and making those adjustments could help hedge the risks that keep many investors up at night. I have been wondering, however, about the permutations of these moves and the effect they could have on a portfolio. For example, how does credit perform when equities fall, and how do income-oriented stocks perform in a rising-rate environment? I also wanted to know the impact of making both of these moves at the same time. Would this increase or decrease portfolio diversification, return potential, and volatility? In other words, by addressing one risk, would investors be unwittingly introducing another? In this commentary, I'll share the results of my analysis, which may help answer these questions.


In this analysis, Core Fixed Income (Core FI) is represented by the Barclays US Aggregate Bond Index. Credit is represented by a 50% allocation to the Barclays US High Yield Index, 25% allocation to the Credit Suisse First Boston Leveraged Loan Index, and a 25% allocation to the JP Morgan Emerging Markets Bond Index Plus. Equity Income is represented by the MSCI US Investable High Dividend Yield Index. Equity is represented by the MSCI US Investable Index. The Barbell Portfolio is represented by a 50% allocation to Core FI and a 50% allocation to Equity as defined below. The Bullet Portfolio is represented by a 50% allocation to Credit and a 50% allocation to Equity Income as defined below. Historical performance is measured beginning in January 1996. The analysis is meant to be illustrative of various strategies, however, actively managed mutual fund strategies or index strategies related to these indexes may have experienced markedly different results.

Strategy Proxy Used
Core FI Barclays US Aggregate Bond Index
Credit 50% Barclays US High Yield Index, 25% Credit Suisse First Boston Leveraged Loan Index, 25% JPMorgan EMBI+
Equity Income MSCI US Investable High Dividend Yield Index
Equity MSCI US Investable Index
Barbell 50% Core FI, 50% Equity
Bullet 50% Credit, 50% Equity Income
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1 For the indexes mentioned in the methodology, please see the definitions below.

The Barclays U.S. Aggregate Bond Index covers the U.S. investment-grade, fixed-rate bond market. It is comprised of government securities, mortgage-backed securities, asset-backed securities, and corporate securities to simulate the universe of bonds in the market.

The Barclays U.S. Corporate High Yield Index covers USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds.

The Credit Suisse First Boston Leveraged Loan Index is a representative index of tradable, senior secured, U.S.-denominated non-investment grade, floating rate loans.

The JP Morgan Emerging Markets Bond Index Plus (EMBI+) is a market capitalization weighted USD-denominated sovereign emerging-markets index of the most liquid issues in the asset class.

The MSCI USA Investable Market Index (IMI) High Dividend Yield Index is based on MSCI USA IMI, its parent index, and includes large, mid and small cap stocks. The Index is designed to reflect the performance of equities in the parent index (excluding REITs) with higher dividend income and quality characteristics than average dividend yields that are both sustainable and persistent

The MSCI USA Investable Market Index, includes over 2,400 large-, mid- and small-cap U.S. stocks.

High-level Look at Risk and Returns

When making asset allocation decisions, it's good to start by considering the risk/reward trade-offs of various approaches. Figure 1 plots the historical volatility and return characteristics of the approaches I analyzed. As expected, Equity Income exhibited less volatility than Equity and delivered somewhat lower returns. Core FI displayed the lowest volatility (with less than half that of Credit), but at the expense of lower returns. The Bullet and Barbell Portfolios were in the middle -- they produced similar returns but with lower volatility in the Barbell. Figure 1 is a reminder that higher returns tend to come with more risk, except when diversification with an uncorrelated asset can achieve higher returns with similar risk, as shown with the Barbell and Credit.

Figure 1

Figure 2 provides a more detailed look at the historical characteristics of these approaches. Within fixed income, the maximum 12-month loss in Credit (-26%) dwarfed that of Core FI (-2%), while the maximum 12-month gain for Core FI (15%) has paled in comparison to that of Credit (50%). Credit has also had a relatively high correlation with Equity (0.68), while Core FI had essentially no correlation (-0.03). During rolling 12-month periods, Credit was positively correlated with equities in 99% of the periods, compared with Core FI, which had a positive correlation just 43% of the time. Credit had an upside capture ratio of 100%, meaning that when Core FI increased, Credit increased, on average, 100% as much. Credit's downside capture ratio of -1% indicates that Credit did provide protection when Core FI had a negative return.

Among equities, Equity was more volatile than Equity Income, and returns for Equity were marginally better. As one would expect, increasing exposure to Equity Income appears to dampen volatility at the cost of some upside capture. While the maximum 12-month gains and losses for Equity and Equity Income are nearly identical, the upside capture of Equity Income was 75% that of Equity. For some investors, this may be an acceptable trade-off, especially considering that Equity Income's downside capture was 59%, meaning that when Equity fell, Equity Income fell by about 59% as much as Equity.

Looking at the Bullet and Barbell Portfolios, the key takeaways are that the median 12-month returns were similar, but the Barbell exhibited less volatility, thanks to the diversification benefit of adding Core FI exposure to Equity. In addition, the maximum 12-month gain and loss were significantly smaller for the Barbell than for the Bullet. It may be surprising to see the high correlation of the Barbell to equities, given that half of the allocation of this approach is to Core FI. Because equity returns are generally much more volatile than Core FI returns, they tend to dominate the direction of a portfolio's movement, which, in this case, has increased the Barbell's correlation with equities.

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Effects of Rising Rates and Equity Sell-Offs on Each Strategy

Because investors are concerned with how rising rates and/or a sell-off in equities could impact investments, I examined the historical performance of various approaches in these environments. Figure 3 shows the historical performance during recent periods of rising rates, while Figure 4 shows the historical performance of the same sets of assets during recent equity sell-offs.

Rising Rates:

Core FI and Credit

I compared the performance of Core FI and Credit during four recent periods when U.S. 10-year government bond yields (a proxy for interest rates) rose substantially. Credit outperformed Core FI in all four periods. It's not surprising that Credit, which has had a high correlation to US equities, would outperform in rising-rate scenarios, as rate increases tend to occur when economic growth is strong and equities generally benefit. In these environments, Credit spreads tend to tighten.

Equity and Equity Income

The performance of Equity Income and Equity during periods of rising rates is also intuitive. In all four periods, Equity outperformed Equity Income, mainly because equities with higher dividend yields tend to have greater interest-rate sensitivity, because as interest rates rise their dividend yields become relatively less attractive.

The Bullet and the Barbell

During periods of rising interest rates, the Barbell and the Bullet Portfolios delivered mixed results. On a relative basis, the Bullet's higher exposure to Equity Income detracted, as Equity Income rose less than Equity. This was in spite of the fact that Credit outperformed Core FI. Incidentally, while neither strategy produced consistently better returns during periods of rising rates, the Barbell had lower volatility in all four rising-rate scenarios, thus providing mostly better risk-adjusted returns than the Bullet.

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Equity Sell-Offs:

Core FI and Credit

Examining periods of large equity sell-offs revealed the potential risk of moving from Core FI to Credit. In each of the three periods I studied, Core FI produced positive returns, acting as a counterweight to negative equity returns (Figure 4). Contrast these results with negative returns for Credit in all three periods of equity weakness. While Credit historically offered protection against rising rates, its high correlation with (and positive beta to) US equities made this market segment an ineffective hedge in an equity sell-off.

Equity and Equity Income

Equity Income fared much better than Equity in two out of three scenarios. The only period in which Equity Income did not provide protection was during the recent global financial crisis, when both asset classes lost over 50%. Thus, while Equity Income strategies experienced lower losses relative to Equity, among all the strategies, Core FI was the main source of downside protection, delivering a positive return in all of the historical equity sell-off scenarios.

The Barbell and the Bullet

During equity sell-offs, the Barbell was disadvantaged by having half of its allocation to Equity at a time of equity underperformance. Largely because Core FI was the only strategy that delivered a positive return during equity sell-offs, the Barbell had higher returns than the Bullet in two out of the three equity sell-offs. This highlights the importance of retaining exposure to Core FI during Equity sell-offs. The Bullet was helped during these periods by Equity Income's better performance relative to Equity.

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Conclusion: Maintain a Strategic Risk Balance

Investors should remember that shifting their portfolio allocations to reduce one potential risk may introduce another. A clear example of this unintended consequence is moving out of traditional fixed income into credit-oriented strategies in order to reduce interest-rate risk. While this move does make a portfolio less sensitive to rising interest rates, it also increases the potential for larger losses during an equity sell-off. This is because credit strategies have historically had positive correlations to equities. In the same vein, moving out of equity strategies and into dividend-oriented equity strategies may lower downside equity risk but increase the interest-rate sensitivity of the portfolio. This is because income-oriented stocks' dividends tend to make them more bond-like.

Many investors may not realize that in a portfolio made up of credit and equities, performance has historically been largely dependent on equities. Traditional fixed-income holdings play an important diversification role because of their historically low or negative correlation to equities. Even if interest rates rise, any losses in fixed income are likely to be overshadowed by gains in equity-related assets, since most portfolios tend to be dominated by equity and other assets that respond well to growth environments.

In sum, higher interest rates and a drop in the equity market are potential risks on the horizon that can derail portfolio performance. Since no one knows for sure when or if these risks will materialize, it is important to construct a portfolio with a risk balance that provides the potential for more stable long-term performance across various market environments.

Investment Implications

  • If you're worried about rising rates: Think twice about replacing traditional fixed income with credit. Credit has significant equity risk and may provide significantly less protection in an equity sell-off. Consider reducing the duration of your fixed-income allocation or complementing it with credit-oriented or more flexible fixed-income strategies that can alter duration. Remember that if rising rates are driven by better growth prospects, growth-oriented equity strategies may outperform defensive equity strategies.
  • If you're worried about an equity sell-off: Think twice about replacing growth-oriented equity strategies with defensive-equity strategies. Defensive equities have bond-like qualities and may underperform if rates rise. Consider adding high-quality fixed income, which has historically had low or negative correlations to equities and have produced positive returns in equity sell-offs, thus mitigating losses.
  • If you want to simultaneously hedge a portfolio against rising rates and an equity sell-off: Consider the underlying economic environments, which might trigger this market response, and be sure to have assets that will respond positively in each one. Remember that risk balance and diversification matter, and carefully consider your strategic asset allocation before abandoning or downsizing traditional fixed income (weak-growth asset) or more aggressive equity (strong-growth asset) allocations. For more information, please see our 2013 paper, "Think Function, Not Form 2.0: Putting Asset Allocation Assumptions to the Test." This paper is only available to financial advisors and other institutional investors.

Investors should carefully consider the investment objectives, risks, charges, and expenses of Hartford Funds before investing. This and other information can be found in the prospectus and summary prospectus, which can be obtained by calling 888-843-7824 (retail) or 800-279-1541 (institutional). Investors should read them carefully before they invest.

A Word About Risk: All investments are subject to risks, including possible loss of principal. Fixed-income investments are subject to interest-rate risk (the risk that the value of an investment decreases when interest rates rise) and credit risk (the risk that the issuing company of a security is unable to pay interest and principal when due) and call risk (the risk that an investment may be redeemed early). Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Foreign investments can be riskier than U.S. investments. Potential risks include currency risk that may result from unfavorable exchange rates, liquidity risk if decreased demand for a security makes it difficult to sell at the desired price, and risks that stem from substantially lower trading volume on foreign markets. These risks are generally greater for investments in emerging markets. The U.S. government guarantees the timely payment of principal and interest for U.S. Treasury bonds.

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management.

All information and representations herein are as of 6/14, unless otherwise noted.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.