In the third part of this series, we extended our simple ranking system to include risk targeting. This extended analysis produced a portfolio that could deliver higher risk-adjusted returns than a simple ranking system and still deliver a yield in excess of the Bloomberg Barclays Global Aggregate Bond Index. In the final part of this series we will look at the same strategy and examine its sensitivity to changes in interest rates.

Why Does High Income Help Protect Against Changing Interest Rates?

Let’s begin by looking at why high levels of current income can potentially protect against rising interest rates. To examine this phenomenon, we will start with a very simple analysis comparing high-yield bonds to Treasurys. We will assume we have a high-yield bond with a duration of four years and a yield of 5.85% and a Treasury with a duration of four years and a yield of 1.71%. These numbers are based on the December 2016 benchmark yield curves.

Next, let’s assume that we had a relatively smooth year and then, suddenly, we are surprised with a 1% increase in benchmark interest rates. Figure 1 below shows the net impact.

Figure 1: Hypothetical Impact from a 1% Increase in Rates with a $1 Million Initial Investment

December 2016

In this case, the high-yield bond investor walks away with some money in their pocket while the Treasury bond investor has lost over 2% of their initial investment. There are other ways this could play out because high-yield investors are affected by other macroeconomic events. However, in terms of interest rates, this analysis is fair. In short, higher income is one way we can protect against rising interest rates.

Expanding Our Risk Targeted Yield Portfolio

Before we look at how our risk-targeted yield portfolio would protect against rising rates, let’s give it a leg up on the competition by allowing the portfolio to hold stocks when it fits within the targeted level of risk. Stocks have a lower sensitivity to changing rates than bonds. By including them, we will naturally reduce our exposure to changing rates. Additionally, certain stock asset classes sometimes offer yields that are in excess of bonds, which will offer even more opportunities for income. Figure 2 lists all the asset classes we will include in this analysis. Finally, we will give a little more room to allow for stocks by increasing the risk target to 6.5%—the long-term standard deviation of a blended benchmark of 15% MSCI All Country World Index and 85% Bloomberg Barclays Global Aggregate Bond Index.

Figure 2: All Assets

The results below show the initial analysis compared to the prior risk-targeted yield portfolio of 5% and the blended benchmark.

Figure 3: Risk-Targeted Yield Analysis With and Without Stocks

August 1998–December 2016

By adding stocks and increasing the risk target, we increase the volatility of our initial portfolio, but the similar Sharpe ratio indicates that the extra risk is made up for. Plus, it is still superior to simple benchmark exposure. Going forward, we will refer to risk-targeted yield as the version that includes stocks. Now we need to examine how sensitive this expanded yield portfolio is to changing interest rates. However, before we move on to that topic, let’s get a quick refresher on the relationship between interest rates and bond prices.

An Inverse Relationship

Imagine that we bought a bond at par for $1,000 that was paying a 5% coupon, which means each year we will receive interest payments in the amount of $50. Presumably at the time we buy that bond, a 5% coupon is in line with the current market rates. However, a year later, the market rates for similar bonds have a coupon of 6%; in other words, interest rates rose. A bond that pays 5% can no longer be sold for $1,000 because similar bonds with the same value are now paying more interest. So the value of the bond needs to be marked down in order to make up the difference in interest payments. On the other hand, if a year later the market rate for similar bonds falls to 4%, that means the interest rates declined, which makes our 5% coupon bond more valuable because it pays more interest than the current market rates. As a result, the value of our bond rose.

Now that we have the basic relationship between interest rates and bond prices, let’s examine what happens to our risk-targeted yield portfolio.

The Impact of Rising Rates

Below is the correlation and beta of the Bloomberg Barclays Global Aggregate Bond Index and the expanded risk-targeted yield portfolio compared to changes in Treasury yields. Note that the signs of beta and correlation are reversed to make is easier to relate the change in interest rates to changes in overall portfolio value. I reverse the sign of beta and correlation because the relationship between prices and yield is inverse.

Figure 4: The Relationship to Changing Interest Rates

August 1998–December 2016

This analysis demonstrates that roughly 80% (indicated by the beta of 0.80) of the benchmark’s return can be explained by changes in interest rates and roughly 80% (indicated by the correlation of 79.4%) of the benchmark’s weekly returns are in the same direction as changes in interest rates. So as rates go up, prices go down. This dynamic is not the case for our risk-targeted yield portfolio, which shows numbers closer to 0, meaning the relationship is statistically insignificant. This means risk-targeted yield portfolio is less exposed to the risk of changes in interest rates.

We can also do a historical analysis as well by looking at interest rate changes in excess of +/-0.25% a month. Below are the results of that historical analysis.

Figure 5: Average Monthly Return in Different Rate Environments

August 1998–December 2016

There is clearly a statistical representation of lower risk in the Risk-Targeted Yield Portfolio, as seen in Figure 4. And here in Figure 5 we see that, empirically, the Risk-Targeted Yield Portfolio has been less exposed to interest-rate risk. Next, we can take our newfound knowledge and put it into action.

Putting It All Together

Finally, we will review how a combined portfolio of traditional bonds and the risk-targeted yield portfolio operates and what the impact would be to changing rates in Figure 6. I will also expand our universe to explore the possibility of using only Treasurys or munis as the bond component of a blended portfolio.

Figure 6: Combining Bond Assets With the Risk-Targeted Yield Portfolio

August 1998–December 2016

Now we’re cooking with gas! As suspected, including risk-targeted yield into the core bond asset classes dramatically improved performance, raised the yield and cut in half the sensitivity to interest rats changes. The most surprising of the bunch is the combination with Treasurys, which has the highest Sharpe ratio of any of the portfolios. This outperformance actually makes sense considering the Treasury portfolio and risk-targeted yield portfolio are uncorrelated with each other; in other words, risk-targeted yield is a great diversifier for a traditional Treasury portfolio. The muni combo is also attractive, but the analysis doesn’t factor in any tax benefit. If we added in an after-tax return, the Sharpe ratio would likely be similar to the Treasury portfolio.

This draws to a close our series on Income Investing in an Uncertain World. We learned that by applying active selection through carry and/or momentum analysis can greatly improve the yield and risk-adjusted return of an income portfolio. We also saw that by adding in some risk management in the form of risk targeting, we can dramatically improve the active selection process. Finally, we took what we learned and constructed an income portfolio that draws from our risk-targeted yield and traditional bond asset classes in order to create a portfolio with excellent risk-adjusted performance, higher income and a lower overall sensitivity to interest rates changes. Not a bad start to any income portfolio!