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INVESTMENT PORTFOLIO BEHAVIOURIN A RISING INTEREST RATE ENVIRONMENT

2INVESTMENT PORTFOLIO BEHAVIOUR IN A RISING INTEREST RATE ENVIRONMENT

UNDERSTAND THE PAST TO PREPARE FOR THE FUTURE

EXECUTIVE SUMMARY

As major developed economies have been oper-ating for such a long time in an environment of historically low interest rates and could enter a phase of interest rate rises towards the end of the year, investors should consider adjusting the mix of their investments in order to protect and enhance their portfolio performance.In an effort to examine the behaviour of invest-ment portfolios with regards to performance and risk measurements, as well as derive a range of effective strategies for addressing the poten-tial risks associated with an interest rate rise, we have conducted a case study of the impact of the U.S. Fed’s interest rate rising actions during the period of 1982 – 2015. While past performance does not guarantee fu-ture results, studying previous rate hike periods can provide us with a valuable insight towards managing investment portfolios entering a rising rate environment. Our findings show that both

equities and bonds have appeared to record a better performance during periods of slow-paced interest rates rises, while in the opposite case, the behaviour of various asset categories appears to be more complex. While there is no simple answer regarding the manner in which rising interest rates affect var-ious asset classes because of the complexity of factors involved (severity and magnitude of the increase, frequency and time length of incremen-tal rises, state of the economy), we have presented a range of strategies for protecting and enhancing investment portfolios as we approach the start of a series of interest rate rises in major global econ-omies such as the U.S. and the U.K. In perspective, however, asset allocation adjustments must al-ways be tailored around the individual investor’s specific requirements as well as risk tolerance.

3INVESTMENT PORTFOLIO BEHAVIOUR IN A RISING INTEREST RATE ENVIRONMENTUNDERSTAND THE PAST TO PREPARE FOR THE FUTURE

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PART ICASE STUDY: FED DURING 1982-2015 PERIOD

Context

Definition of Fed Funds Rates

Interest Rates Hiking Process

Today’s Picture

Past Interest Rate Cycles Analysis

Performance of Equities During Previous Interest Rate Rising Cycles

Performance of Fixed Income Securities During Previous Interest Rate Rising Cycles

PART IIANALYSIS: SHIELDING AND ENHANCING INVESTMENT PORTFOLIOS

Shielding and Enhancing Investment Portfolios in a Rising Interest Rate Environment

Investment Alternatives in Equities

Rebalancing the Fixed Income Securities Mix

Adjusting the Asset Allocation of the Portfolio

Housing Sector and Debt Refinancing

Hedging Against Inflation

The Impact on the Currency and the Importance of Currency Diversification

CONCLUSION

TABLE OF CONTENTS




PART ICASE STUDY: IMPACT OF FEDACTION DURING 1982-2015 PERIOD

In the context of policy interest rates at all-time lows for the major developed economies, investors are sooner or later bound to face a rising interest rate environment, which could be very challenging for managing portfolios. In this paper we present our observations and insights based on a case study that we have performed on the behaviour of investment portfolios with regards to performance and risk measurements during past periods of rising interest rates.

As central banks’ strategies differ from one country to another, for the sake of argument we have chosen the Federal Reserve (Fed) Funds rates as an indicator of a rising/falling interest rate environ-ment.

While past performance does not guarantee future results, studying previous rate hike periods can provide us with a valuable perspective towards managing investment portfolios within a rising rate environment.

EXECUTIVE SUMMARY


DEFINITION OF FED FUNDS RATES AND INFLATION

Fed Funds are overnight loans which banks use in order to meet the requirements at the end of each day. The required amount is set by the Fed and it varies according to the size of each bank.

Inflation represents an increase in the overall price level of goods and services in an economy over a certain time period. Fed policy makers evaluate changes in inflation by examining several different price indices which measure price changes of various sectors of goods and services. As inflation numbers can vary significantly from month to month, policy makers generally focus on average inflation over longer time intervals, ranging from a few months to a year or even longer.

The Federal Open Market Committee believes that an inflation rate close but below the 2.00 percent (yoy) level is healthy for the economy. However, history shows that the Fed Funds rate might have been well above this level in order to curb runaway inflation, or below it in order to stimulate economic growth.



The Fed increases interest rates by raising the target for the Fed Funds rate. Technically speaking, rates are set by the banks themselves rather than by the Fed. However these rates rarely vary from the tar-get rate, as in that case the Fed would use various tools such as discount window, discount rate and re-serve balance supply to name a few, in order to create enough pressure on the banks to meet its target.Central banks begin to raise rates when they are confident that the economy is safely out of recession, or when the economy overheats and inflation is on the rise.

The 10-year U.S. Treasury yield hit an all-time low of 1.40 percent on June 2012 and has since then gradually been moving higher. Furthermore, the current Fed Funds rate is at its all-time low of 0.00 - 0.25 percent range since December 16, 2008.

The current era of low interest rates is a consequence of the unprecedented actions of the Fed and other central banks taken in their effort to handle the global financial crisis. The Fed initially employed traditional monetary policy tools, lowering the Fed Funds target rate from 5.25 percent in September 2007 to a 0.00 - 0.25 percent range by December 2008, where it has since remained. In November 2008, amid near-frozen credit markets, with overnight rates being close to zero and the U.S. economy experiencing the worst recession since the 1930s, the Fed embarked on a Quantitative Easing (QE) program.

INTEREST RATES HIKING PROCESS

TODAY’S PICTURE

Source : JFD Wealth, research.stlouisfed.org

GRAPH I: HISTORICAL 10-YEAR U.S TREASURY YIELD (WEEKLY BASIS)

18

16

14

12

10

8

6

4

2

0

Yield (%) Historical Average (6.44%) Table as of 31 July 2015

1962-01-05

1964-01-05

1966-01-05

1968-01-05

1970-01-05

1972-01-05

1974-01-05

1976-01-05

1978-01-05

1980-01-05

1982-01-05

1984-01-05

1986-01-05

1988-01-05

1990-01-05

1992-01-05

1994-01-05

1996-01-05

1998-01-05

2000-01-05

2002-01-05

2004-01-05

2006-01-05

2008-01-05

2010-01-05

2012-01-05

2014-01-05


One of the most popular market indicators of interest rates for many investors is the Fed’s monetary policy position, therefore the Fed Funds rate is a decisional tool in implementing such policy decisions.

To simplify our analysis, we define a rising rate period as a timeframe when the Fed is tightening its policy.As previously mentioned, Fed Fund rates are raised in order to temper inflation even if has not yet materialised. The Fed’s decision is also influenced by labour markets and economic growth factors. From 1982 to date, we have identified 5 periods of rising interest rates, as listed in TABLE I.

Historical analysis is an objective way of understanding how different asset classes typically respond to periods of rising rates. In our analysis we examine the performance behavior of the two major asset classes in standard portfolios, namely equities and bonds.

PAST INTEREST RATE CYCLES ANALYSIS


Source : Research.Stlouisfed, JFD Brokers

GRAPH II: FEDERAL FUNDS TARGET RATE

TABLE I: RISING RATE PERIODSTable as of 31 July 2015, Benchmark: Federal Funds Target Rate

10

8

6

4

2

0

Yield (%) Period Table as of 31 July 2015

1982-09-27

1983-09-27

1984-09-27

1985-09-27

1986-09-27

1987-09-27

1988-09-27

1989-09-27

1990-09-27

1991-09-27

1992-09-27

1993-09-27

1994-09-27

1995-09-27

1996-09-27

1997-09-27

1998-09-27

1999-09-27

2000-09-27

2001-09-27

2002-09-27

2003-09-27

2004-09-27

2005-09-27

2006-09-27

2007-09-27

2008-09-27

2009-09-27

2010-09-27

2011-09-27

2012-09-27

2013-09-27

2014-09-27

II III IV VI

PERIOD NUMBER

BEGIN DATE

END DATE

LENGTH (YEARS)

BEGIN RATE (%)

END RATE (%)

ITERATIONS

YIELD CHANGE (%)

I

31.03.1983

09.08.1984

1,36

8,50%

11,50%

12

3,00%

II

29.03.1988

17.05.1989

1,13

6,5%

9,8125%

16

3,3125%

III

04.02.1994

01.02.1995

0,99

3,00%

6,00%

7

3,00%

IV

30.06.1999

16.05.2000

0,88

4,75%

6,5%

6

1,75%

V

30.06.2004

29.06.2006

2,00

1,00%

5,25%

17

4,25%



Market participants believe that rising rates are bad for stocks, in other words if interest rates rise and therefore the discount rate moves higher, stock prices should theoretically go down. When interest rates are high and investors are offered “risk-free” yields for their hard-earned cash, they would be inclined to park their money in the bank rather than take any chances with stocks, which have no guar-antee on their returns or even on receiving their initial capital invested. The opposite belief holds in the case of low interest rates.

However this does not necessarily hold true according to the findings of TABLE II, which shows the S&P 500 Index performance following the five previous periods of rising interest rates, as already defined in TABLE I. In fact, if rates are moving higher as a result of the Fed’s belief that the economy is improving, the influence of stock prices will be a positive one.

Furthermore, TABLES III (A) and (B) indicate that different interest rate rising periods lead to equity performance disparities. The velocity of interest rate change within a specific period, is defined by granularity, which is the ratio of percentage yield change over the number of iterations during the period (Granularity = Yield Change / Iterations).

PERFORMANCE OF EQUITIES DURING PREVIOUS INTEREST RATE RISING CYCLES


TABLE II: PERFORMANCE OF S&P 500 INDEX DURING PAST RISING RATE PERIODS

Table as of 31 July 2015, Benchmark: Federal Funds Target Rate & S&P 500 Index

PERIOD NUMBER

BEGIN DATE

END DATE

LENGTH (YEARS)

PERFORMANCE OVER PERIOD

ANNUALISED PERFORMANCE

MAX. DRAWDOWN

VOLATILITY

I

31.03.1983

09.08.1984

1,36

7,91%

5,75%

-14,38%

12,79%

II

29.03.1988

17.05.1989

1,13

28,8%

25,0%

33,5%

4,00%

III

04.02.1994

01.02.1995

0,99

2,14%

2,16%

8,69%

9,54%

IV

30.06.1999

16.05.2000

0,88

8,5%

9,7%

-12,08%

21,31%

V

30.06.2004

29.06.2006

2,00

11,50%

5,61%

7,70%

0,61%


TABLE III (A): GRANULARITY

TABLE III (B): GRANULARITY & EQUITY PERFORMANCE

GRAPH III: MAR RATIO vs GRANULARITY

Table as of 31 July 2015, Benchmark: Federal Funds Target Rate

Table as of 31 July 2015, Benchmark: Federal Funds Target Rate & S&P 500 Index

Here we define a normalised measure of the performance, the MAR Ratio, as the ratio of annualised performance over maximum drawdown (MAR ratio = Annualised Performance / Maximum Draw-down).

The findings of TABLES III (A) and (B) suggest that the lower the granularity (i.e. when interest rates rise at a slow pace), the better the performance of equities appears to be. The same conclusion can be drawn from GRAPH III, which shows the relationship between the MAR ratio and granularity, indi-cating that equities have performed more strongly in periods of low granularity.

Source : Research Stlouisfed, JFD Brokers

Source : Research Stlouisfed, JFD Brokers, Stooq.com

Source : Research Stlouisfed, JFD Brokers, Stooq.com

PERIOD NUMBER

BEGIN DATE

END DATE

YIELD CHANGE (%)

ITERATIONS

GRANULARITY

I

31.03.1983

09.08.1984

3,00%

12

0,25000%

II

29.03.1988

17.05.1989

3,3125%

16

0,20703%

III

04.02.1994

01.02.1995

3,00%

7

0,42857%

IV

30.06.1999

16.05.2000

1,75%

6

0,29167%

V

30.06.2004

29.06.2006

4,25%

17

0,25000%

PERIOD NUMBER

GRANULARITY


MAX. DRAWDOWN

MAR RATIO

I

0,25%

5,75%

-14,38%

0,40

II

0,21%

25,0352%

-33,5100%

0,75

III

0,43%

-2,16%

-8,69%

-0,25

IV

0,29%

9,70%

-12,08%

0,80

V

0,25%

5,61%

-7,70%

0,73

Table as of 31 July 2015

0,80

0,60

0,40

0,20

0,00

-0,20

-0,40

0,00% 0,05% 0,10% 0,15% 0,20% 0,25% 0,30% 0,35% 0,40%



Source : Research Stlouisfed, JFD Wealth, Bloomberg

TABLE IV: PERFORMANCE OF BARCLAYS U.S. CREDIT INDEX DURING PAST RISING RATE PERIODSTable as of 31 July 2015

Interest rate rise expectations are causing fear among bond investors around the possible negative impact on their portfolios. In general, as the fixed interest associated with the underlying securities begins to appear less attractive with interest rate rises, the price of these instruments decreases. The longer the bond’s maturity is, the more sensitive the instrument becomes to interest rate rises. Bonds are therefore not all equally affected by interest rate changes.

To examine the relationship between interest rates and bond values of different market categories and durations, we have chosen the following five benchmarks:

The findings of the performance of the various fixed income indices during previous periods of rising interest rates are outlined in TABLES IV through VIII:

PERFORMANCE OF FIXED INCOME SECURITIES DURING PREVIOUS INTEREST RATE RISING CYCLES

NUMBER

1

2

3

4

5

INVESMENT TYPE1

Corporates

High Yield

Treasury

Treasury

Treasury

BLOOMBERG TICKER

Corporates

High Yield

Treasury

Treasury

Treasury

INDEX

Barclays US Credit Index

Barclays U.S. Corporate High Yield Index

Barclays U.S. 1-3 Year Treasury Bond Index



PERIOD NUMBER

BEGIN DATE

END DATE

LENGTH (YEARS)



MAX. DRAWDOWN

VOLATILITY

I

31.03.1983

09.08.1984

N.A

N.A

N.A

N.A

N.A

II

29.03.1988

17.05.1989

N.A

N.A

N.A

N.A

N.A

III

04.02.1994

01.02.1995

0,99

-3,20%

-3,23%

-7,64%

6,29%

IV

30.06.1999

16.05.2000

0,88

-0,1%

-0,2%

-3,87%

4,80%

V

30.06.2004

29.06.2006

2,00

5,54%

2,74%

-3,28%

3,68%


TABLE V: BARCLAYS CORPORATE HIGH YIELD PERFORMANCE DURING PAST RISING RATE PERIODS

TABLE VI: BARCLAYS U.S. TREASURY 1-3 PERFORMANCE DURING PAST RISING RATE PERIODS

TABLE VII: BARCLAYS U.S. TREASURY 3-7 PERFORMANCE DURING PAST RISING RATE PERIODS

Table as 31 July 2015, Benchmark: Federal Funds Target Rate & Barclays Corporate High Yield

Table as 31 July 2015, Benchmark: Federal Funds Target Rate & Barclays U.S. Treasury 1-3

Table as 31 July 2015, Benchmark: Federal Funds Target Rate & Barclays U.S. Treasury 3-7



Source : Research Stlouisfed, JFD brokers, Stooq.com

PERIOD NUMBER

BEGIN DATE

END DATE

LENGTH (YEARS)



MAX. DRAWDOWN

VOLATILITY

I

31.03.1983

09.08.1984

N.A

N.A

N.A

N.A

N.A

II

29.03.1988

17.05.1989

N.A

N.A

N.A

N.A

N.A

III

04.02.1994

01.02.1995

0,99

-1,82%

-1,84%

-4,69%

4,66%

IV

30.06.1999

16.05.2000

0,88

-1,8%

-2,1%

-3,44%

2,60%

V

30.06.2004

29.06.2006

2,00

15,31%

7,40%

-5,29%

2,38%

PERIOD NUMBER

BEGIN DATE

END DATE

LENGTH (YEARS)



MAX. DRAWDOWN

VOLATILITY

I

31.03.1983

09.08.1984

N.A

N.A

N.A

N.A

N.A

II

29.03.1988

17.05.1989

N.A

N.A

N.A

N.A

N.A

III

04.02.1994

01.02.1995

0,99

1,24%

1,25%

-1,49%

2,03%

IV

30.06.1999

16.05.2000

0,88

3,5%

4,0%

-0,55%

1,25%

V

30.06.2004

29.06.2006

2,00

3,61%

1,79%

-0,81%

1,15%

PERIOD NUMBER

BEGIN DATE

END DATE

LENGTH (YEARS)



MAX. DRAWDOWN

VOLATILITY

I

31.03.1983

09.08.1984

N.A

N.A

N.A

N.A

N.A

II

29.03.1988

17.05.1989

N.A

N.A

N.A

N.A

N.A

III

04.02.1994

01.02.1995

0,99

-2,52%

-2,54%

-4,55%

3,94%

IV

30.06.1999

16.05.2000

0,88

2,2%

2,5%

-1,04%

2,42%

V

30.06.2004

29.06.2006

2,00

3,18%

1,58%

-1,83%

2,75%



All categories had their worst performance during period III, which experienced the highest granu-larity. Furthermore, shorter term Treasuries performed the best when compared to the other four categories during the same period. High yield and corporate bonds, as well as longer term Treasuries performed better during the last period of lowest granularity.


TABLE VIII: BARCLAYS U.S. TREASURY 7-10 PERFORMANCE DURING PAST RISING RATE PERIODSTable as 31 July 2015, Benchmark: Federal Funds Target Rate & Barclays U.S. Treasury 7-10

PERIOD NUMBER

BEGIN DATE

END DATE

LENGTH (YEARS)



MAX. DRAWDOWN

VOLATILITY

I

31.03.1983

09.08.1984

N.A

N.A

N.A

N.A

N.A

II

29.03.1988

17.05.1989

N.A

N.A

N.A

N.A

N.A

III

04.02.1994

01.02.1995

0,99

-5,21%

-5,26%

-7,97%

6,11%

IV

30.06.1999

16.05.2000

0,88

1,5%

1,8%

-3,77%

5,63%

V

30.06.2004

29.06.2006

2,00

4,58%

2,27%

-4,72%

4,71%


A wide range of investors across the board, including retirees living on fixed income as well as institutional investors such as pension funds, are all being squeezed by historically low interest rates and therefore are desperately trying to come up with alternative ways of generating suf-ficient income sources for their portfolios.

Interest rates have been drifting lower all around the globe during the past few years and have been remaining at historic lows in several countries for an extended period, however the economies that begin to recover will experience rising interest rates once again, catching both short as well as long term fixed-income and equity investors off-guard. What strategies can investors employ in

order to shield or even enhance their portfolios in a rising interest rate environment?

There is no simple answer when it comes to the manner in which rising interest rates affect var-ious asset classes, due to the complexity of fac-tors involved, such as the severity of the increase, the magnitude of the rise, the frequency/time length of incremental rises, as well as the state of the economy.

When interest rates initially begin to rise during an economic cycle, the impact on the stock market is a positive one, as it is a reflection of the improving economy.

PART IIANALYSIS: SHIELDING AND ENHANCING INVESTMENT PORTFOLIOS

SHIELDING AND ENHANCING INVESTMENT PORTFOLIOS IN A RISING INTEREST RATE ENVIRONMENT



The early stages of an economic expansion have therefore historically been good for stock prices. If long-term interest rates are rising as the result of stronger economic growth, then companies with cyclical earn-ings should benefit. Many companies within the industrial and energy sectors are commonly linked to economic growth, and in particular con-sumer discretionary stocks such as luxury brands, tend to excel in periods of stronger economic growth.

In the later stages of the economic cycle, however, when the economy begins to run too hot and prices increase too rapidly, the Fed would move to slow economic growth through monetary policy by rising interest rates, which could put a lid on stock market growth. Rising rates could create a slowdown in housing, as well as possibly motivate stock inves-tors to take profits off the table, selling stocks, reducing demand and causing a decline.

Some types of stocks have more interest rate sensitivity than others. They behave more like bonds and would likely see a drop in price as rates move up, however other parts of the stock market would likely only tumble if rates moved contrary to expectations.

THE FOUR PHASES OF ECONOMIC CYCLE

EARLYRECESSIO

N

MID

LATE

4 PHASES

Act

ivity

Rebounding

Cre

dit Begin

s to Grow

Rap

id P

rofits G

rowth

Pol

icy

Still C

umulative

Low

Inventories

Growth Peaks Credit Grow

th StrongProfit Grow

th PeaksInventories Sales G

rowth

Equilibrium ReachedIm

provin

g Sales

Growth M

oderate

s

Credit Tig

htens

Earnings Struggl

ing

Inventories G

row

Sales Grow

th F

alls

Grow

th Peaks C

redit Growth Strong

Profit G

rowth PeaksInventories Sales Growth

Eq

uilibrium Reached


A well-diversified, all-weather portfolio that will withstand shocks throughout the various phases of the economic cycle, is the most efficient ap-proach towards the challenging task of correctly timing the market. In general, based on the find-ings of our study already outlined, there have been periods during which stocks have benefitted when interest rates rose. In fact, equities tend to perform well if interest rates rise at a slow pace, as long as the state of the economy is healthy and improving; along with that improvement come in-creased revenues and profits, therefore stocks do not necessarily have to decline as rates rise. On the other hand, due to the Fed’s low interest rate policy, many bond investors have been forced to find riskier assets. Rather than playing it safe with Treasury securities or investment-grade corpo-rate bonds, traditional fixed-income investors have moved up the risk ladder to dividend-paying stocks and other investments that pay a high div-idend, such as real estate investment trusts (RE-ITs).

Investors who have added high-dividend-paying stocks such as those of utility, telecommunication companies and REITs to their portfolios in the last few years, might find it prudent to move away from such investments which are interest rate sensitive, and switch instead their portfolios to-

wards a more diversified, total return approach.Moreover, there are a few different types of com-panies which benefit from an economic uptick and thrive in a rising rate environment, such as in-formation technology and industrial companies.

An alternative strategy for hedging against the risk of a selloff in the event that investors pan-ic and rush for the exit when rates begin to rise sharply, would be to switch into stocks of major consumers of raw materials; the price of raw ma-terials usually continues to remain stable or even decline in a rising rate environment, while the companies using these materials experience a drop in their costs and consequently an increase in their profit margins. Such companies are there-fore considered to be a hedge against inflation and rising rates.

In the context of international diversification, global dividend stocks potentially offer higher income and therefore outperformance. Emerging market stocks, on the other hand, may experience significant declines as the Fed begins the interest rate hike process, as several emerging markets’ substantial U.S. debt exposure will become even more burdensome in the event of U.S. interest rate rises.

The primary purpose of bonds has historically been to produce safe income for cash-flow needs. In today’s low interest rate environment this is extremely difficult to accomplish by investing in government bonds, investment-grade bonds or municipal bonds, as absolute yields are currently zero to negative.

The secondary role of bonds within a diversified portfolio is to insulate the portfolio from loss-es during economic recessions and equity bear markets. Typically, the Fed lowers interest rates during recessions, extended market corrections and the periodic bear market. As market interest rates decline, the price of quality bonds and bond

REBALANCING THE FIXED INCOME SECURITIES MIX

INVESTMENT ALTERNATIVES IN EQUITIES



fund rises in response to these lower interest rates. The positive performance of a quality bond portfolio in times of stress helps to balance the decline in risk assets such as stocks, as in the case of the Asian contagion in 1997, the 2000–2002 bear market and the 2008 bear market.

As we have already seen in our study, the worst place to be invested in when rates are rising, are bonds or bond funds with long maturities and low coupons, such as longer term Treasuries. These securities are the most vulnerable to price de-clines, as the principal will only be repaid in the longer term and the low coupon is not sufficient to compensate for the bond price drop due to the rate rise.

When, however, interest rates rise more gradual-ly and over a longer period of time, fixed income underperformance is not as severe, since bonds earn a higher amount of interest income over this longer period, which in turn offsets the loss-es from their price decline. Moreover, if rates are rising for the right reasons—stronger economy, more jobs, greater demand for loans/credit—then high-yield bonds should hold up well, and float-ing-rate bonds (such as bank debt) should also perform well.

Therefore a rising rate environment is not neces-sarily a bad thing when it does not happen in an abrupt, uncontrolled manner, as it could actual-ly allow investors who need income, to reinvest principal that comes due from their bonds at high-er rates. What would raise a concern, however, is the potential behaviour of bond investors panick-ing in the event of a rate rise and a price decline in their bond holdings, as many of them would be rushing for the exit and this could, at least in the short term, cause a disruption in the liquidity and pricing of all bond types.

Furthermore, bonds with higher coupons and shorter duration such as high-yield corporate bonds (or junk bonds), are better insulated from price declines. These are bonds issued by cor-porations that are below investment grade and usually offer higher coupons in order to attract capital. The higher coupon and generally short-er maturities imply a lower price sensitivity to interest rate changes. As long as the economy is

robust and the issuing companies of these corpo-rate bonds are healthy, bond prices tend to be less affected by rising rates than investment-grade corporate bonds, as the higher-coupon (or yield) helps to absorb price declines.

Floating-rate bonds is another category of invest-ments issued by corporations below investment grade and they also better insulated from price declines. These bonds pay a floating rate of in-terest that typically adjusts monthly or quarterly. There are two advantages to these investments: (a) when shorter-term rates rise, the interest paid by these bonds increases when they hit the reset period (monthly or quarterly), and (b) the price sensitivity of these bonds is much lower because of the periodic interest-rate reset. Therefore, the pricing of these bonds is more stable during rising rate environments.

Furthermore, it is wise to keep sufficient cash and/or very short duration bonds in the portfolio, in order to be able to meet any spending needs that may arise in the 12 to 18 months that follow an interest rate rise.

Bond laddering is an effective strategy of restor-ing balance and discipline in fixed income portfo-lios when approaching a period of rising interest rates. It involves keeping the fixed-income part of the portfolio relatively liquid, by holding a series of bonds maturing at regular intervals (such as ev-ery three, six, nine or 12 months), so that as rates rise and as each bond matures, it gets reinvested at a higher rate.

Holding the right mix of bonds (government bonds, municipal bonds, investment-grade, high-yield corporates, floating-rate, etc.) and timely rebalancing it accordingly, is the key to insulating and enhancing an investment portfolio. Signifi-cantly reducing the holdings with longer matur-ities and lower yields (investment grade bonds) and switching them into high-yield and high-qual-ity non-investment grade corporate bonds, as well as long/short bond funds, are alternative solutions for hedging some of the inherent risks associated with price declines when interest rates eventually rise.


The proportion of an investor’s assets allocated to bonds and other categories may well be the most important decision investors make. Allo-cating money across stocks, bonds and cash, is far more significant on long-term returns than individual investment selection. In periods of approaching interest rate rises, it becomes even more important to adjust the asset allocation mix in order to protect the return of the portfolio. For many years, the rule of thumb for most long-term investors was 60/40, a 60 percent allocation

in stocks and 40 percent in bonds. Besides being a simple rule, less volatile and lower-return bonds were meant to smooth out the ups and downs of the riskier stock market while giving investors some of the greater possible gains of stocks. According to Vanguard, an investor with a 60/40 allocation can expect an average annual return of 8.9%, based on data going back to 1926.

However, the traditional 60/40 approach towards building a portfolio is now being replaced by “tac-tical” asset allocation, a strategy in which inves-tors change their allocation based on the current pricing of asset classes. If bonds are overpriced, and stocks are under-priced relative to other assets, then the allocation should shift toward stocks and always balance out the riskier assets in a portfolio.

One strategy would be to reduce the amount invested in high-yield bonds and move it into stocks that pay high dividends, using an options strategy to lock in gains and protect against market drops, or maintain a large allocation in fixed income, but weigh it heavily towards Trea-sury inflation-protected securities (TIPS), whose yields rise with inflation.

ADJUSTING THE ASSET ALLOCATION OF THE PORTFOLIO

THE MIXTURE OF ASSETS DEFINES THE SPECTRUM OF RETURNSBest, worse, and average annual returns for various bonds/stocks allocations, 1926-2014

Note: Past performances does not guarantee future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Stocks are represented by the Standard & Poor’s 90 Index from 1926 through March 9, 1957, the S&P 500 Index from March 4, 1957, through 1974; the Dow Jones Wilshire 5000 Index from 1975 through April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, to June 2, 2013; and CRSP US Total Market Index thereafter. Bonds are represented by S&P High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1927; Barclays U.S. Long Credit AA Index from 1973 through 1975; and the Barclays U.S. Aggreegate Bond Index thereafter. Data are through December 31, 2014.

Source: Vanguard.

BONDS

STOCKS

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

60%

50

40

30

20

10

0

-10

-20

30

-40

-50

32.6% 31.2% 29.8% 28.4% 27.9%

-18.4%

32.3%

-22.5%-26.6% -30.7% -34.9%

-39.0%-43.1%

36.7% 41.1%46.4% 49.8% 54.2%

Average

-8.1% -8.2% -10.1% -14.2%

5.5% 6.1% 6.8% 7.4% 7.9% 8.4% 8.9% 9.3% 9.6% 9.9% 10.2%



In general, precious metals such as gold, which are tangible assets, per-form better in a low interest rate and rising inflation environment. When interest rates start to move higher in order to curb inflation, however, the performance of such inflation hedging investments deteriorates. Furthermore, oil and other natural resources also suffer in a rising in-terest rate environment. As already mentioned, an alternative to hedge against inflation would be to hold stocks of companies that consume such resources, as the cost of material goes down and the profit margins for these companies increase.

The housing market is heavily dependent on mortgage lending. Rising interest rates trigger a plummet in housing along with mortgage applica-tions, as they make it more costly to buy a home. Furthermore, a contrac-tion in the housing market has a negative effect on related businesses such as manufacturers of appliances and items used in the home con-struction process. A weak housing market can also hinder the banking sector as it reduces loan activity.

Prudent investors could lock their debt/mortgage at current rates ahead of an expected rise. Investors who are eligible to refinance their house, would be currently urged to do so. Although it is often difficult to predict the exact time and magnitude of a rate increase, if eligible, it is advised to take the opportunity to refinance while interest rates are still at historic lows and avoid a steep increase in loan repayments.

HEDGING AGAINST INFLATION

HOUSING SECTOR AND DEBT REFINANCING


When interest rates rise as a consequence of a monetary policy tightening, the value of the cur-rency tends to increase as higher interest rates tend to attract global investors to U.S. denom-inated income yielding investments and bank deposits, thus boosting demand for the currency.

The greatest challenge of having a strong U.S. Dollar occurs at a macro level, as it could pose a significant impact on the Balance of Trade, causing a rise of imports and decline in exports as U.S. goods and services become more expensive; as a consequence, American exporting compa-nies suffer and eventually economic growth and hiring are hampered. Moreover, major U.S. mul-tinationals suffer from an erosion of their profits when they translate their overseas earnings into U.S. Dollars.

The biggest losers from a stronger dollar in a healthy economic environment, however, will are the corporate borrowers. The rise in interest rates assumes that the cost of borrowing also increases. Domestic companies tend to borrow money at a faster pace in an effort to lock in their loan and bond rates at lower interest rates ahead of a potential rise. While in a historic low interest rate environment these companies have benefited from cheap borrowing which enabled them to buy back shares as well as pay dividends to shareholders, which in turn has made them appear more attractive to market participants, all of these benefits are poised to end as soon as interest rates begin to rise.

Most importantly, a stronger U.S. Dollar effec-tively transfers demand from the U.S. economy to other economies around the globe. A stronger U.S. currency makes domestic products appear less competitive in the international market, while the products of other struggling economies with weaker currencies such as Europe and Japan will appear more attractive and their exports could be boosted on the back of a stronger U.S. Dollar.

There have been three major periods of a stronger U.S. Dollar since the recession of 1973-1975. During the first period, October 1978 – March 1985, the U.S. Dollar strengthened by more than 52.50 percent, while the S&P 500 index surged by more than 70.00 percent. The second period which occurred from mid-1005 to early-2002, during which the U.S. Dollar appreciated by 35.00 percent while the S&P 500 index gained more than 100.00 percent. In the third period which is still underway, the U.S. Dollar has risen sharply by more than 25.00 percent between the trough in mid-2011 and the peak in February 2015.

In our study we have observed the behavior of the U.S. Dollar index during the three aforementioned major periods. The U.S. Dollar index is defined as a measure of the value of the U.S. Dollar relative to a basket of several major currencies, namely the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and the Swiss Franc.

THE IMPACT ON THE CURRENCY AND THE IMPORTANCE OF CURRENCY DIVERSIFICATION



Out of the five periods examined earlier in GRAPH II when the Fed increased interest rates, only in one case the U.S. Dollar index appreciated when a sharp increase of 1.50 percent was recorded, whereas in two cases the currency depreciated

and in the other two it remained unchanged. More specifically, the Fed increased interest rates in May 1982 through October 1983 from 8.50 to 10.00 percent, while at the same time the U.S. Dollar index experienced high gains exceeding

Source : Macrotrends.net

Source : jfdbrokers.com

GRAPH IV: U.S. DOLLAR INDEX HISTORY

GRAPH V: U.S. DOLLAR INDEX AND S&P 500 INDEX PERFORMANCE

As indicated in GRAPHS IV and V, each of the three long periods of U.S. Dollar strength coincided with higher stock prices, as U.S. equities tend to perform well as a result of capital flowing from around the world into investments and deposits in the United States.

130

1975 1980 1985 1990 1995 2000 2005 2010 2015

1978 - 1985

1995 - 2002

2011 - 20??

125

120

115

110

105

100

95

90

85

80

Real Dollar Index - Broad Real Dollar Index - Major Real Dollar Index - Other

120%

Oct. '78 - Mar. '85 Jul. '95 - Feb. '02 Jul. '11 - Feb. '15

100%

80%

60%

40%

20%

0%

U.S. Dollar Index

% C

HA

NG

E

S&P 500 Index

52.5%

75.5%

35.8%

103.2%

25.8%

58.9%


$10.00. Interestingly enough, this rise in the U.S. Dollar index coincides with the first phase of a strong U.S. Dollar during the 1978 to 1985 period, as shown in GRAPH IV.

The second phase of ten consecutive Fed rate hikes occurred from January 1987 to February 1988, lifting the interest rate from 6.50 to 9.75 percent. The U.S. Dollar index suffered huge losses prior to the Fed’s rate action, from the $128.45 peak level in March 1985 down to $102.00 at the start of the interest rate rise process in January 1987. In this case, the Fed action did not prevent the negative momentum of the currency and the sharp correction continued to cause a plunge of more than $35.00 in the U.S. Dollar index from its March 1985 peak.

From February 1993 to February 1994, while the Fed increased its benchmark rate from a record low of 3.00 percent all the way up to 6.00 percent, the U.S. Dollar index level remained unchanged and moved in a sideways channel roughly around the $90.00 region.

Following the trough below the $85.00 level on December 1994, the U.S. Dollar index gained more than $20.00 during a strong U.S. Dollar era that persisted for seven years, from 1995 to 2002. The U.S. Dollar index consequently paused roughly around the $105.00 region despite the rate increase during the period of June 1998 - May 1999, when the Fed decided to increase its benchmark rate from 5.00 to 6.50 percent.

The bull market of the U.S. Dollar index ended in February 2002 when the index reached a sev-enteen year high at $116.65. In December 2003 the U.S. Dollar index came under pressure and fell below the critical level of $100.00 during the bear market of the 2002 - 2011 period and recorded two critical consecutive troughs, the first one at $84.40 in April 2008 and the second one at

$80.50 in July 2011.

The most recent interest rate rise action by the Fed was recorded prior to the global financial crisis of 2006. During the period of June 2003 - June 2005, the interest rate was increased seventeen consecutive times, from 1.00 to 5.25 percent, and remained at the latter level during the year that followed. The impact of this action on the U.S. Dollar index was surprising to many market participants, as it experienced a sharp correction of more than 10.00 percent annually during this period.Since the two troughs below the $85.00 level in April 2008 and July 2011, the U.S. Dollar index has been moving one way, gaining more than 20.00 percent over the past four years.

The U.S. Dollar poses a dilemma to Fed poli-cymakers as they face the challenging task of addressing the need to increase interest rates in a growing economy in order to achieve their eco-nomic goals, while maintaining market calm and stability. The currency strength became more apparent over the last couple of years, especially since the second quarter of 2014, on the back of the Fed officials’ comments opening the door to the possibility of an interest rate increase as the U.S. economy started to show healthy signs of recovery. The anticipation of a rate rise signal from the Fed, has triggered a flow of funds into U.S. Dollar denominated assets in search of higher returns, lifting the value of the currency to higher levels.

The same argument applies to the performance of the British Pound, as several Bank of England policymakers have noted that the possibility of an interest rate hike decision may be possible in the next few months (this will be the subject of an analysis in one of our future case studies under our White Paper series).



Source : Saxobank

GRAPH VI: COMPARISON OF U.S. DOLLAR INDEX AND S&P 500 INDEX

In addition to the importance of increasing the exposure of strengthening major currencies in the portfolio such as the U.S. Dollar and the British Pound, avoiding investments in emerging markets denominated currencies would be rec-ommended when discussing currency diversi-fication. As already mentioned earlier under “Investment Alternatives in Equities”, a U.S. rising interest rate environment will trigger U.S. Dollar

appreciation against other currencies and espe-cially those of emerging market economies; the total debt burden of these economies amounts to several trillions of U.S. Dollars which will become even heavier as their debt in real local-currency value will increase due to the U.S. Dollar appre-ciation, causing a shock on financial institutions, corporations, households as well as the local cur-rencies.

125

115

120

110

100

105

95

85

90

80

70

65

75

U.S. Dollar Index S&P 500 Index

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015


In this paper we have studied the behavior of investment portfolios with regards to performance and risk measurements during previous interest rising cycles going back to 1982. Our findings show that when interest rates rise at a slow pace, in general both equities and bonds have appeared to record better performance during periods of slow-paced interest rates rises.

Due to the complexity of factors involved, however, such as the severity of the increase, the magnitude of the rise, the frequency/time length of incremental rises, as well as the state of the economy, predicting exactly how major asset classes such as stocks and bonds will behave when interest rates start to rise, is a difficult task.

While we have outlined a number of strategies for rebalancing investment portfolios in order to protect and enhance them as we head towards the start of a series of interest rate rises in major global economies such as the U.S. and the U.K., it still remains an extremely challenging job. Bottom line is, however, that that all asset allocation plans must always be tai-lored to each investor’s circumstances and risk tolerance.

Furthermore, based on the continuing improvement of the U.S. economy and the Federal Reserve Fed rhetoric signaling that a period of rising rates may be on track during the last quarter of this year, the expecta-tions for U.S. Dollar interest rates to begin rising are quite high, which would in turn further boost the U.S. Dollar value against other currencies as it will attract foreign capital to U.S. Dollar denominated instruments. It is therefore extremely important to take into account the potential out-performance of currencies such as the U.S. Dollar (as well as the British Pound) over other major currencies in the context of currency diversifi-cation of an investment portfolio.

CONCLUSION



Anthony LESOISMIERHead of Financial Market AdvisoryMain: +357 25 878530 | Fax: +357 25 763540

Efthivoulos GRIGORIOUHead of Global Research and AnalysisMain: +357 25 878530 | Fax: +357 25 763540

CONTACTS


DISCLAIMER

The information contained herein is based on sources we believe reli-able, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only. The Authors make no representations or warranties, express or implied. The information is not intended to be taken as advice with respect to any individual situ-ation and cannot be relied upon as such. Readers are cautioned not to place undue reliance on any historical, current or forward-looking state-ments. The Authors undertake no obligation to update or revise publicly any historical, current or forward-looking statements, whether as a re-sult of new information, research, future events or otherwise.

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