How to respond to lower interest rates?

Working man with headset
15-03-30 10:00 | Markets and investments | Fredrik Wilander

Investors increasingly feel the challenges that come with low interest rates. The exceptionally low short and longer-duration interest rates most likely have resulted in lower expected future returns from fixed income (the only plausible outcome unless one expects interest rates to continue to drop from these levels). And, not only have interest rates dropped, but it is increasingly likely they will stay low for longer before they eventually will start to rise, at least in Europe.

Low for longer

Why does it matter for expected fixed income returns when interest rates will rise? Let’s say an investor wants to estimate expected annual money market and government bond returns over the coming 10 or 20 years and consider two scenarios:

A parallel upward yield curve shift in year 1, and then no changes in yields for the remaining years.

Stable low yields for all but the last year, and then the same parallel yield curve shift as in 1) only now it is happening at the very end of the period.

Average annual returns from both money market and government bonds will be higher in 1). Money market returns will be higher since the average short rate is higher in the first scenario. Government bond returns will also be higher in 1). Although an investor in scenario 1 takes an early capital loss from yields rising, after that the investor enjoys many years of higher bond yields. In the second scenario the investor gets the same capital loss albeit at the end of the period, but no higher running yields to compensate.

So, the the depressed levels of yields, coupled with the realization that yields may stay low for a long time, have likely resulted in substantially lower expectations on fixed income returns. What does that imply for portfolio management/asset allocation?

Portfolio effects from lower return expectations

If we consider ourselves to be in a Markowitz world, a lower expected return on fixed income asset classes would result in the efficient frontier shifting down (assume that asset class volatilities and correlations are unchanged).

How could an investor potentially react to this? Essentially there are three options:

1. Keep the current asset allocation: This would result in a lower expected portfolio return (since the expected return on some of the asset classes have fallen, and the portfolio return is just a weighted average of asset class returns). With unchanged volatilities and correlations, portfolio volatility will be unchanged. However, downside risk as measured by Value at Risk (VaR) will become more negative (worse for the investor). VaR measures the worst expected outcome over a given horizon with a given confidence level. It depends positively on expected return and negatively on volatility. A lower expected return all else equals thus worsens VaR.

2. Keep the currenct VaR: An alternative for the investor is to try to preserve the VaR. Given that the expected return on the portfolio has fallen, to achieve unchanged VaR, portfolio volatility must also fall. With unchanged volatilities and correlations, the only way for this to happen is to change portfolio allocations by selling high risk assets and buying low risk assets. Very likely this means selling equities and buying fixed income. This alternative thus preserves VaR, reduces portfolio volatility, but ultimately leads to a larger drop in expected return than in 1).

3. Keep the current expected return: As we saw in 1), with unchanged allocations the expected portfolio return will fall. One way to compensate for this is to change the asset allocation mix in the opposite way from 2) by adding higher expected return assets such as equities, and selling lower expected return assets which is likely to be fixed income. The drawback of this is naturally that portfolio volatility will rise and Value at Risk become more negative, most likely more negative than in 1).

No right answer

Which of the alternatives should an investor choose? Unfortunately there is not one correct answer. It depends on what the investment goals are and especially what parameter is driving portfolio construction (a target return, a risk budget, a preference for stable allocations etc.). What is important is to have an informed view on how the low yield environment affect asset class expected returns and risks, and how this in turn impacts the portfolio return and risk metrics.

For investors already holding well-diversified portfolios of domestic and international equities, and fixed income investments of varying credit and interest rate risk, it might very well that not changing allocations but rather moderating the expectations for future returns, is the most suitable option. Another important point is that interest rates are not low everywhere. For a European investor, diversifying also into international fixed income can increase the return potential and mitigate the effect of ultra-low domestic interest rates and partly offset the associated downward shift in the expected return/risk-possibility space.

Latest blog posts from Fredrik Wilander

Showing 5 of 8 results

Woman advicing man

On the merits of international diversification

Markets and investments Fredrik Wilander

Fredrik Wilander

Investing close to home

Markets and investments Fredrik Wilander

Who’s who among private investors?

Markets and investments Fredrik Wilander

Fredrik Wilander

Hold on to high yield

Markets and investments Fredrik Wilander

When love and hate correlate

Markets and investments Fredrik Wilander

Financial markets have over the past few weeks seen increased tension and volatility.

Showing 5 of 8 results