Rising Rates Good For Long Term Investors

With the Fed holding steady on interest rates this month, many investors continue to think about what they should or shouldn't do when rates do begin to rise. Vanguard’s Senior Economist Roger Aliaga-Diaz explained to ETF.com that for long-term investors in a diversified fixed-income portfolio, there’s really not much to do except for maybe a few tweaks to credit and duration. But from his perspective, a rising-rate environment means a healthy economy, which is of course a good thing for any long-term investor. Aliaga-Diaz will be speaking at this year’s ETF.com Fixed Income conference, taking place Nov. 4-5 in Newport Beach, California.

ETF.com: Investors are being bombarded about the Fed raising rates. How concerned should investors be, and what should or shouldn’t they be doing?
Roger Aliaga-Diaz: When the Fed raises rates shouldn’t matter that much for the long-term investor. What sets the path for rates—from the first hike to how fast and how far they go afterward—is economic fundamentals. And by that I mean progress in the labor market and economic growth, which we are seeing. Inflation is also getting back to the Fed's target. We’re not there yet, but we're going to see inflation eventually recover back to the 2 percent level.

From a perspective of real economy, with the progress we’ve seen in the labor market, it shouldn't matter whether the Fed acts in September, in December, or even if it had done something in June. The path for rate increases is going to be gradual.

In spite of this progress in the labor market, the global environment continues to be weak. The Fed cannot operate in a vacuum. Basically, the divergence in monetary policy is so important right now that it would put a limit on how high the Fed can go.

Because of all that, we anticipate a very subdued and gradual rise in rates over the next two, three years, four years. We’ll perhaps get to a lower level of no more than 3.5 percent, compared with 4-5 percent in the past. The markets are pricing in something even weaker than that.

ETF.com: If you're diversified in your fixed-income holdings, should you even be concerned about what's going on with the Fed raising it so slowly and gradually?

Aliaga-Diaz: It really depends on how the economy is doing. If you have a well-diversified portfolio, there should be a little bit of duration exposure there in case things don't go as well as we were thinking in the first place, say, if yields don't increase as fast as expected.

But you also want to correlate with some credit, because if things go a little bit faster than expected—say, the economy's picking up faster than we thought—the credit sector is going to do better. We're going to see spread compression. That type of diversification is a good approach for a long-term investor.

Rising rates are something good for long-term investors. People should be happy about it. Portfolio managers and traders don't like it because surprise rate hikes create capital losses on a day-to-day basis. But if you're a long-term investor, higher rates mean you're investing at a higher rate of return, and as long as your investment horizon is longer than the maturity or the duration of the bond portfolio, you should be fine. You should actually benefit from higher rates in spite of the volatility in the front end.

ETF.com: We've seen some new ETF products come to market with rising interest rates in mind, such as interest-rate-hedged and floating-rate bond ETFs. Can investors get in trouble thinking, “Well, interest rates are going up so I need this protection”?

Aliaga-Diaz: The important thing to know is that there’s never a free lunch with any of these products, like hedging. It's a choice of how much volatility you’re willing to take and the return you’re giving up for getting rid of that volatility.

Even hedged interest rate funds will basically give the same return as unhedged ones in the long, long horizon, because any hedged contract will roll. Over a 10-year period, you may be in the same place, whether or not you hedged it, as interest rates rise.

Aliaga-Diaz (cont'd.): With the hedge, you may get rid of some of the volatility along the way, and in that sense, a hedge could be appealing. But there will be a premium to pay for that insurance aspect of the hedge.

So again, the key point is that there’s no free lunch. A long-term investor should probably not worry too much about the day-to-day moves in the interest rate because of the higher volatility in interest rates.

ETF.com: Does it give you pause for concern when you hear about the Chinese selling their U.S. Treasurys as a way to help prop up their own stock market?

Aliaga-Diaz: There's definitely the concern that they can’t manage to stabilize their monetary policy and economy. We don't anticipate that, but that's clearly concerning.

When China sells Treasurys, it's because the Chinese private sector is buying them. So in some sense, they're trying to stabilize their currency. They’re leaning against all the private capital flows.

At the end of the day, the private sector has gone from bringing capital into China to basically moving out of China. We have seen a huge capital outflow over the last few months. That means Chinese investors are buying dollar-denominated debt, Treasurys. And that's why the central bank needs to sell, to match that demand, just so the economy does not get completely offhand.

Keep in mind that in July/August, the total outflow of sale of Treasurys from China was $100 billion to $150 billion. It's a significant amount. But the global Treasury daily market volume is $500 billion. It’s the most liquid market in the world. That’s to say that $130 billion or so over a month versus $500 billion daily volume should be absorbed without any disruption.

ETF.com: When you look around in the fixed-income space, what attracts you right now? Is there anything in particular that maybe is a little different than a year or two ago?

Aliaga-Diaz: The fixed-income markets and the emerging markets have seen a lot of pain and stress. We may start seeing that things are not as bad as we thought on the emerging market front and on the China front in terms of the economy. Economic fundamentals in China are not in as bad shape as it seems.

I can think of a scenario in which the Fed decides to raise rates. Then the global markets look at the rate increase, they understand it's not the end of the world and they move on. In that scenario, emerging markets could be a surprise.

ETF.com: Some of the high-yield bond ETFs, in particular, have had it rough since around May. Have these bonds built in an interest-rate increase already?

Aliaga-Diaz: We can’t forget about the tight correlations corporate bonds and high-yield bonds have to equity markets. That has created a little bit of a head wind, with the spreads widening. But there could come a point when wider spreads give room for good performance if U.S. economic fundamentals continue to be on the strong side, and if the Fed normalization goes as planned.

Similar to emerging markets, I can see a scenario in which the Fed raises rates and the economy continues to post really good numbers on the job front, and we see some indication that inflation is getting better. We know that with a strong economy, usually corporates tend to do better. And starting from a high level of spreads, there is some room for that to happen.

ETF.com: I imagine you have some kind of forecast models. Where have you forecast yields on the 10-year Treasury bond to be a year from now?

Aliaga-Diaz: The way we think about it is, we start with a path for fed fund rates. With the type of gradual interest rate rise we're talking about, for example, the fair value for the 10-year yield would be in the 2.5 to 2.7 percent range. Because of that, we would see a very gradual increase from that price point a year from now.

ETF.com: Is it a safe assumption then to also say we're not going to see much in terms of an increase in mortgage rates?

Aliaga-Diaz: Yes, but the other thing to keep in mind is that over the next year, the Fed needs to start unwinding its balance sheet. And it seems that, if anything, it would start with the mortgage-backed securities it holds. There could be some volatility from that.

Contact Drew Voros at [email protected].