March 2021
The Big Interest Rate Move
KEY OBSERVATIONS

Interest rates have been rising steadily for months. Still, February’s move was jarring: Five-, 10-, and 30-year Treasury yields all rose over 30 basis points (bps) in the month, a rise that was sharp enough to rattle equity markets by month’s end. The sharp rally happening as we write this piece on March 1 is a reminder that rising rates are driven by an improving economy—and that stocks can do just fine. The ISM Manufacturing PMI released on March 1 served as just such a reminder, coming in at an extremely high 60.8. This is a level far in excess of the 50 level that marks economic expansion, and higher than any level we saw coming out of the Great Recession.

February Brought Losses in the Bond Market

When interest rates rise, bond prices fall, and indeed there were losses across the bond market in February. Of note, inflation expectations have barely moved, driving losses for Treasury Inflation-Protected Securities (TIPS)—a place where many investors forget they are exposed to the risk of rising Treasury yields. Tightening spreads in the high yield market managed to keep that segment in the green (see our Fixed Income section for more). However, it took explicit interest rate hedging to drive a materially positive result, as noted by performance of the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index.


CHART OF THE MONTH:
It Was a Tough Month for Bonds

Bond Index Returns, February 2021

Source: Bloomberg. Treasury Inflation-Protected Securities (TIPS) tracked by the Bloomberg Barclays U.S. Treasury Inflation Notes Index, Aggregate U.S. Bond market tracked by the Bloomberg Barclays U.S. Agg Bond Index, Corporate Bonds tracked by the Bloomberg Barclays U.S. Corporate Bond Index, High Yield Bonds tracked by the Bloomberg Barclays U.S. Corporate High Yield Index, Investment-Grade (Interest Rate-Hedged) Bonds tracked by the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index. Data from 02/01/21 to 02/28/21. Performance quoted represents past performance and does not guarantee future results.


The long-term average 10-year U.S. Treasury yield has been around 4%, reflecting around 2% inflation and 2% real yield. Both current and expected inflation are not so far off that long-term average, but real Treasury yields remain predominantly negative. Further increases in U.S. Treasury yields may very well represent further increases in real yield. Still, a somewhat vigilant Fed makes a 4% 10-year yield unlikely until quite far off into the future. However, 2.5% may not be, and investors may want to consider this when constructing their fixed income and equity portfolios.


PERFORMANCE SNAPSHOT

Equities—with the exception of U.S. Large Cap Growth, which returned 0.0%—remained in the green despite a late-month pullback. Most fixed income ended in the red.

Returns of various common market segments

Source: Bloomberg. Performance quoted represents past performance and does not guarantee future results.



Equity Perspectives
Interest Rates and Equity Performance

Late February’s backup in yields rightly gave fixed income investors—especially those carrying meaningful levels of duration—much anxiety. Equity investors were also caught up in the fray, as solid returns halfway through the month dissipated, especially for high-priced growth stocks. The sudden change in rates has reignited an important question: Can equities perform well if rates continue to go higher from today’s levels?

Duration is a measure of bond price sensitivity to a change in interest rates.


The conventional wisdom is that rising rates are bad for stocks for two primary reasons: 1) borrowing costs increase, which crimps future corporate profits, 2) stocks get discounted back to a lower present value based on a higher discount rate. The argument perhaps takes on an added dimension given some of the market segments that have delivered exceptional returns of late. Many earlier-growth stage technology names, as well as stocks with high price-to earnings multiples, are in effect long-duration assets. Much of their perceived value is tied to profits and cash flows that are not expected to materialize for several years in the future. The longer out into the future those profits are produced, and the higher their price-to-earnings ratios, the higher their sensitivity to changes in interest rates.

Price to earnings is the ratio of the price of a stock (or index) to the earnings per share of the trailing 12-month period.


All that said, empirical evidence has proven that stocks can do just fine with higher rates. Despite being in a secular declining rate environment for 30 years, there have been several sustained periods in recent years in which rates have spiked, and equities have nonetheless delivered strong returns. The pace of rate changes and the reasons for change are important factors to decipher. And Treasury bond yields, even after their most recent increase, are still below levels where they may compete with stocks as a source of income.

Dividend Opportunities in a Rising Rate Environment

Equity investors seeking refuge from swings in rates may consider dividend growth strategies. Companies that have historically grown their dividends can make up an all-weather strategy. On average, the S&P 500 Dividend Aristocrats have strong histories of profit and growth and have delivered attractive returns regardless of the direction of interest rates.

In the most recent five periods of rising interest rates dating back to 2009, dividend growth, as represented by the Aristocrats, has outperformed high dividend yield, as represented by the Dow Jones US Select Dividend Index, in three of those periods. A rising income stream—the Aristocrats have raised their dividends at a compound annual growth rate of over 8% annually since 2005—can be thought of as an added bonus in the event the Fed is successful in engineering a gentle nudge to inflation.

S&P 500 Dividend Aristocrats Index Performed Well in Prior Rising Rate Periods

Source: Morningstar.


Periods of Rising Rates (Depicted as Shaded Bars Above)

Rising Rates Periods Dates Increase in 10-Year U.S. Treasury Yield S&P 500 Dividend Aristocrats Index (Dividend Growth) Dow Jones US Select Dividend Index
(High Yield)
Period 1 12/31/08-3/31/10 1.6% 32.3% 18.5%
Period 2 8/31/10-3/31/11 1.0% 21.2% 22.1%
Period 3 7/31/12-12/31/13 1.6% 26.0% 20.9%
Period 4 7/31/16-10/31/18 1.7% 8.5% 8.3%
Period 5 7/31/20-2/28/21 0.9% 15.2% 29.2%

Source: Morningstar. Data from 12/31/2008 to 2/28/21. Dividend growth tracked by the S&P 500 Dividend Aristocrats Index; High yield tracked by the Dow Jones U.S. Select Dividend Index. Performance quoted represents past performance and does not guarantee future results. Dividend yield is the ratio of cash dividends paid to market value per share.



Fixed Income Perspectives
And So It Begins…

While we have written about a likely rise in interest rates for some time, the speed at which the 10-year Treasury yield spiked was a tad unexpected, though not unprecedented. The yield on the 10-year rose 34 basis points (bps) in February, but since the turn of the 21st century, a month-over-month spike of this size or more has occurred on 17 separate occasions. So, what is so eye-popping this time around?

The key here is that rates across the yield curve were, and still remain, close to all-time lows. Let’s change gears for a second. When you purchase a stock, the upside potential is limitless, while your losses are limited to your initial purchase price. When we think about Treasury yields and the current state of play, almost the opposite is true. Interest rates can only fall so far, with Fed Chairman Powell consistently rejecting the use of negative rates as a policy tool. But there is plenty of room for them to continue rising.

Ten years ago, the Fed was utilizing expansionary monetary policy, keeping the Fed Funds rate close to zero in the wake of the financial crisis. Flash forward to today, and we continue to hear that Fed officials are willing to let the economy run hot prior to raising the target for the Fed Funds rate above zero. Whether the Fed is concerned that we are not yet at full employment, or that we are not at the long-term inflation target, the message remains the same. So, we find ourselves asking, when will the Fed raise its benchmark rate? The answer is unclear; however, the key here is that we are asking “when” it will happen, not “if.” While there are many apparent differences between the state of the economy now versus 2011, a quick look at the differences in long-term rates can be quite jarring.

A Striking Contrast Between Long-Term Rates in 2011 and Now

Source: Bloomberg. Performance quoted represents past performance and does not guarantee future results.


What’s a Bond Investor to Do?

While longer-term rates have fallen from the recent highs reached on February 25, their upward trend has become apparent. A variety of tools exist to help mitigate interest rate risk in bond portfolios, but reduced risk often means reduced return potential. Increased credit exposure is an area of the market that may help avoid limiting upside potential in a rising rate environment. As mentioned previously, high yield bonds, which involve additional credit risk, including loss of principal, were one of the few segments of the fixed income market that eked out a positive return in February.

As the economy continues to improve, credit spreads are likely to continue tightening. Investment-grade credit spreads tightened 7 bps in February, while high yield spreads tightened 36 bps and counteracted the negative impact of rising rates. The question bond investors should be asking themselves is where they are more comfortable taking risk. Treasury bonds are a well-known safe haven asset in times of market turmoil, but their upside potential is quite limited if the economy continues to improve. A potential way to reduce interest rate risk while maintaining full credit exposure includes that of an interest rate-hedged strategy. These types of fixed income strategies that rely predominantly on credit risk as a source of return have performed quite well since long-term rates bottomed out on August 8, 2020 and may continue to do so if the upward trend in rates resumes.

Source: Bloomberg. Investment Grade (Interest Rate-hedged) Bonds tracked by the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index, High Yield Bonds tracked by the Bloomberg Barclays U.S. Corporate High Yield Total Return Index (Value Unhedged), Corporate Bonds tracked by the Bloomberg Barclays U.S. Corporate Total Return Bond Index (Value Unhedged), Treasury Bonds tracked by the US Treasury Total Return Index (Unhedged) Aggregate U.S. Bond market tracked by the Bloomberg Barclays U.S. Agg Bond Index (Value Unhedged), Data from 8/4/20 to 2/28/21. Performance quoted represents past performance and does not guarantee future results.


ProShares Investment Strategy Team



Sources for data and statistics: Bloomberg, FactSet, Morningstar, ProShares

The different market segments represented in the performance recap charts use the following indexes: U.S. Large Cap: S&P 500 TR; U.S. Large Cap Growth: S&P 500 Growth TR; U.S. Large Cap Value: S&P 500 Value TR; U.S. Mid Cap: S&P Mid Cap TR; U.S. Small Cap: Russell 2000 TR; International Developed Stocks: MSCI Daily TR NET EAFE; Emerging Markets Stocks: MSCI Daily TR Net Emerging Markets; Global Infrastructure: Dow Jones Brookfield Global Infrastructure Composite; Commodities: Bloomberg Commodity TR; U.S. Bonds: Bloomberg Barclays U.S. Aggregate; U.S. High Yield: Bloomberg Barclays Corporate High Yield; International Developed Bonds: Bloomberg Barclays Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced. The fixed income section uses the following indexes: The Aggregate U.S. Bond market is tracked by the Bloomberg Barclays US Agg Bond Index; high yield bonds are tracked by the Bloomberg Barclays US Corp High Yield Index; the broader investment-grade bond market is tracked by the Bloomberg Barclays US Corporate Bond Index; the investment-grade Treasury rate-hedged bond market is tracked by the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index and the FTSE High Yield (Treasury Rate-Hedged) Index; the short-term corporate bond market is tracked by the Bloomberg Barclays US Corporate 1-5 Year Index.

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Bonds will decrease in value as interest rates rise. International investments may also involve risks from geographic concentration, differences in valuation and valuation times, unfavorable fluctuations in currency, differences in generally accepted accounting principles, and economic or political instability. In emerging markets, many risks are heightened, and lower trading volumes may occur. Small- and mid-cap companies may lack the financial and personnel resources to handle economic or industry-wide setbacks and, as a result, such setbacks could have a greater effect on small- and mid-cap security prices.

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