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With the recent selloff in the US Treasury market we have received numerous questions on how to position a portfolio in the face of rising interest rates. To answer that question, it’s important to first look at what factors are causing rates to rise.

In a typical economic cycle, rates rise as economic activity improves, raising demand for credit as well as increasing expectations for future inflation. The Fed then attempts to keep the economy from overheating by raising short-term rates to match the improved economic prospects. In this scenario fixed income instruments generally perform poorly as the higher rates paid for newly issued debt makes existing debt less attractive particularly at longer maturities. Simultaneously, the improved economic conditions will generally result in equities performing well as they reflect expectations for earnings growth and increased pricing power across the economy.

I believe this scenario is, by far, the most likely to play out in the medium term, and it is certainly the scenario that has the most extensive historical precedent. With that in mind, how could an investor reposition a portfolio to navigate this scenario? I would advocate some reallocation from fixed income to equities. Looking at data since 1975[1], a reallocation in the 10-20% range appears to be a reasonable compromise between the increased risk to the portfolio from a larger holding of equities and the goal of protecting against the potential for raising rates.

Within the fixed income component of the portfolio the improving economic conditions will generally result in diminishing concerns of credit default. That provides some boost to returns of credit instruments, which can potentially make up some of the negative effects of rising rates.

There are, however, two additional potential “tail risk” scenarios that can also cause rates to rise:

1: In the “policy error” scenario, the Fed allows improving economic conditions to significantly overheat the economy. This results in a material increase in inflation expectations as well as long-term rates, which may eventually require a painful inflation-fighting contraction. There is only one period in the last 100 years of US history that plays out this way — during the 1970s “stagflation”. Given the significant attention that policymakers have placed on the risks of associated with this scenario, I believe it has a low probability of taking place.

2: In a “loss of confidence” scenario, rates rise in the absence of improving economic conditions simply as a result of creditors pulling away from the market due to concerns about the US government and/or the economy’s ability to meet its obligations. There is no precedent for this scenario in US history, and I believe it to be highly unlikely in the medium term.

For investors who are concerned with these “tail risk” scenarios, a shift to equities may no longer make sense. Instead, a shift to TIPS or other inflation-hedging instruments in the case of scenario 1 or to cash in the case of scenario 2 could be warranted.

Disclaimer: Investors should discuss their own portfolio allocation with their advisors.

Past performance does not guarantee future results.

TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses.

[1] For more details, please see the August 2011 iShares Market Perspectives (pdf).

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Source: Positioning A Portfolio For Rising Rates