We’ve written a lot here and on our sister site BetterBuyAndHold.com about the threat of rising interest rates. You can read some of our past work projecting returns for Treasury ETFs and other interest rate sensitive assets here and here.
In a nutshell, assuming that we’re near the tail end of this 37+ year march lower in interest rates, and in the coming decade(s) rates either rise or remain relatively flat, then Treasuries and similar assets…
- Can still generate big returns in the short-term. Rates can always fall this month or this year, and falling rates boost returns, regardless of how low the current yield is.
- But in the long-term, these assets face very stiff headwinds. In both the rising and steady rate scenarios, these assets will not perform up to the historical norms investors have grown accustomed to. That’s not prognostication; it’s a mathematical certainty.
It’s all a question of investment horizon. Can assets like IEF, TLT, etc. generate the returns investors have grown accustomed to in the coming month or year? Absolutely. Our own projections show as much. Are they likely to do so reliably for the next decade(s)? Not unless you believe that this march lower also continues for the next decade(s), taking us into deeply negative territory.
Taken together, these two observations have a very different impact on investors, depending on whether they employ buy and hold, or whether they take a more tactical (active) approach.
Tactical Asset Allocation (i.e. the thing we do here at Allocate Smartly) should have the ability to reduce allocation to these types of assets when they’re underperforming (1). That means that, conceptually at least, TAA should be less affected by rising rates, because it can still take advantage of short-term bullish periods, while rotating away when these assets struggle (note: despite that, we still model each strategy’s exposure to rising rates for members).
None of this is the case for buy and hold. Buy and hold is not tactical, and can’t rotate away when these assets underperform. More importantly, by its nature B&H has a much longer time horizon that’s measured in multiple years and decades (anything shorter is no longer buy and hold). We know that these assets can perform well in the short-term, but in those long time frames it’s only wise to prepare for them to underperform relative to the past (again, unless you think the march lower continues for many years to come into deeply negative territory).
A well-diversified B&H portfolio must still include US Treasuries and the like, because at the very least they provide a short-term counterbalance to equities and other riskier assets. Put another way, they help to manage the short-term volatility that scares investors into making bad decisions, usually by buying high and selling low. But we have to create our portfolios knowing that these assets are unlikely to perform inline with historical norms. In other words, we need to temper our expectations. By assuming that the past is prologue, we set B&H investors up for disappointment.
That’s a central theme of our sister site BetterBuyAndHold.com. Treasuries and the like are important, they’re just not the reliable return generator that they have been for the last four decades, and expectations should be moderated.
This post was inspired by this thoughtful piece from PortfolioCharts.com (which I assume might have been a response to this analysis). While I appreciate the point that PC is making, telling me that Treasury assets can still generate big returns in the short-term is not really relevant to the long-term nature of Buy & Hold (but it’s very relevant to TAA).
Where an investor lands on the asset allocation spectrum (B&H vs Tactical) determines to what degree they need to consider the impact of this new normal in their investment decisions.
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(1) That assumes that the strategy is measuring the performance of the asset in question, and not simply using it as a “fallback” asset when other unrelated assets aren’t being traded. That’s a subtle distinction that we try to model for members in our special Exposure to Rising Interest Rates report.