What Higher Interest Rates Mean for Your Stock/Bond Mix

On this episode of The Long View, financial planning expert Michael Kitces talks tax-efficient portfolios, higher interest rates, and asset allocation.

Here are a few excerpts from Kitces’ conversation with Morningstar’s Christine Benz and Jeff Ptak:

Asset Allocation and Higher Yields

Christine Benz: That’s a really helpful rundown. Wanted to talk about asset allocation at large. I think that many investors at this stage, especially where we have this relatively new phenomenon—newish phenomenon—of higher yields coming online. Investors are really thinking about, well, how should that affect my asset allocation if these higher safe yields are available? Does that mean I should allocate more to safe assets? I would like you to focus especially on folks who are closing in on retirement or are in retirement.

Michael Kitces: At a high level, I would say from just a pure asset-allocation perspective, higher yields don’t necessarily change the picture just in and of themselves. And really that’s for two reasons. The first is at the end of the day it’s really not about just what, we’ll call it the stated yield, the coupon on the bond—it’s what my yield is after inflation. And the reality is my after inflation, my real returns on bonds, are not particularly much better now than they were several years ago. I’ve gone from almost no yield with almost no inflation to a whole bunch of yield with a whole bunch of inflation. We’ve moved a point or two relatively on where those are in comparison to each other, but it’s not so we can say, well I went from near zero to almost 5% on yields, look at how much more I’m making. It’s like, OK, but when we look at how much more inflation went up as well, we’re not really making much grounds here.

And when we think about that from a retiree perspective, that’s especially impactful because what that means is in terms of my ability to fund my retirement-spending goals and my future retirement-spending goals, I’m really not growing these dollars in any material way above and beyond inflation. I may, or I’m hopefully at least, keeping pace with inflation. But higher yields doesn’t mean I’m beating inflation more and able to fund my long-term goals any better. Because I’m growing my money as much as I’m growing how much my future goals are going to cost, because inflation is lifting up the expense.

The secondary reason why we don’t necessarily look at this as a material difference from an asset-allocation perspective for retirement is if you want to get to the pure economics of how stock returns tend to come about, there’s usually two core components. The first is there’s some risk-free rate that just exists in the marketplace—what I can get if I just park my money somewhere and have it do nothing. There’s a second layer on top of that is then, well, what do I actually get for taking some risk? We usually call this the risk premium. In the context of stocks, we call it the equity risk premium or the stock risk premium. And stock returns, we can generally breakdown to there’s some risk-free rates and there’s some equity premium that sits on top.

When interest rates were very low, the risk-free rate was very, very small and the equity risk premium sat on top. When we put a bigger interest rate on top, the equity risk premium still sits on top of it and so we might even get higher returns out of stocks because it’s sitting on top of a higher risk-free rate in the first place. But the relative difference—how much do my stocks tend to beat my bonds—isn’t necessarily materially different if the bond rate lifts higher, because they move in tandem: one stock stacked on top of each other. And so, when we think about this from an asset-allocation perspective—why do I hold some stocks and some bonds—it usually comes down to two reasons.

I own some stocks on top of some bonds because the stocks give me a risk premium that rewards me in the long run that I need to accumulate for my goals or fund my long-term goals or beat inflation to cover my long-term goals. So, I got some money there, and then unfortunately, coming with that, they’re volatile—they move up and down and sometimes I need money at what is not exactly the best time to sell it. So, I’ve got some bonds that serve as essentially the ballast that balances out the ship that wobbles around with the stocks. And if my stocks are my growth engine and my bonds are my ballast, and stocks generally are going to give the same equity risk premium whether the base bond rate is high or low, the balance of how much stocks and bonds I own doesn’t necessarily really shift all that much.

When we look at this from a pure asset-allocation perspective, I don’t necessarily think about stock bond mix as looking materially different in higher-yield environments versus lower-yield environments. I guess the small asterisk that I would put to that is: When you get down to the purest sense of bonds trying to serve as a ballast to stocks—and that becomes especially important when we’re in early retirement stages. We have the infamous sequence of return risks—what happens if I need to withdraw from my portfolio in the early years and stocks are down in the early years, and if I draw too much from stocks in the early years while they’re down, by the time the market recovery comes, I don’t have enough stocks left to participate fully in the recovery. And then I start running out of money or have to curtail my expenses in the later years.

The extent that the bonds are supposed to provide ballast, bonds that have more yield tend to provide more ballast. Really for two reasons: one, outright, if I’ve got more yield, at least I’m clipping a coupon to generate some return while I’m putting some money in bonds in case stocks go down. And secondarily, while we’ll see if it happens anytime soon, the higher rates are, the more room there is for rates to cut the next time, say bad stuff happens in markets and the economy, and rate cuts create bond-price increases and bond-price increases gives me even more ballast return out of the bonds. And so, when I look at it from that perspective, there is I think more opportunity for bonds to provide that ballast against sequence of return risk to the point that some of the research that we published in the past is that you can hold higher bond allocations early in retirement to help balance that out. I sometimes call it a bond tents.

We’re going to build an extra allocation of bonds in the early years of retirement. If you draw your allocation to bonds, it goes up in the first few years of retirement, then you spend down that extra bond reserve over the next few years of retirement, you get back to whatever your original balance portfolio was that you hold from that point forward. If we want to build a bond tent to protect against sequence of return risk in the early years, and bonds provide a little bit more of a buffer when yields are higher and there’s more room for price appreciation if rate cuts come, it functions as an even stronger ballast in the early years of retirement. So, I do view that as one plus to the environment of having a little bit more yield coming off of our bonds is that that function of bonds not necessarily to be the return driver—the return drivers at the end of the day is the stocks—but to be the balance when the returns in the stocks are not always coming when we wanted them to come. The bonds help a little bit more in this environment.

Higher-Yielding Bonds and Credit-Sensitive Bonds

Benz: Right. So just to clarify though, Michael, you’re not saying within the bond universe, the higher-yielding bonds tend to be more ballast? So, you’re not saying credit-sensitive bonds, they’d be worse ballast, right?

Kitces: Correct. And actually, what we find from some of the research that we’ve done around withdrawals and sequence of return risk, the bonds that do the best work of protecting against the sequence of return risk, ironically, it’s the most boring, lousy-yielding bonds. They’re not there to drive the return. They’re there to be the thing that does well when everything else is going badly. So, if you envision an environment where there’s a horrible economic recession and companies are defaulting left and right and going out of business, which means stocks are cratering at this point. If you think full-on recessions we’ve had at various points—we get one or two every decade or so—when you think about those environments, what’s the worst thing that happens in the bond world? High-yield bonds get crushed; corporate bonds get slammed; and good old-fashioned, not terribly appealing, yielding government bonds, A) continue to crank along their yields, and B) are often the one segment of the bond world that even goes up when everything else is getting slammed in a recession. Because there’s often rate cuts that are occurring and the classic math of bond when rates are going down, prices go up and you get that appreciation.

So just remembering and bear in mind, the point of bonds in a retirement portfolio is not the return driver; it’s the diversifier for the return driver. And so, taking the risks on the bond side that you take on the equity side, which is buying companies that pay better returns in the hopes that the company does well and doesn’t do badly if you’re already taking that risk on the stock side, you don’t need to take it on the bond side—at least from a pure retirement management sequence of return risk perspective.