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Contents of this month’s post include:

• What is Interest Rate Risk and how can it be mitigated?
• Monthly Update for January 2022 with a fresh set of charts

Hi, and good to have you back for another article related to risk balanced portfolio investing!

January 2022 was a shaky month for capital markets, and this turmoil has continued into February as well.

Russia’s invasion of Ukraine’s and a severe violation of a free nation’s sovereignty has certainly caused much volatility on the markets. But the fact is that while conflict is leading to a changed world with a new world order, it is actually not the sole culprit for the turbulence we have seen at late.

Sure, the was has a great impact on commodity prices (more on that later), as, firstly, the sanctions limiting trading with Russian oil, takes a vast amount of barrels of oil off the market on a daily basis, which certainly will drive up prices.

Moreover, Europe has become heavily dependent on Russian natural gas in their energy mix, and perhaps Germany is the country that this would affect the most as a majority of its gas is fed through the Nordstream pipeline and with the now stopped Nordstream 2 having been laid on the floor of the Baltic Sea. If the taps of that Russian oil were to close in the wake of the war, be it on the order of EU or Putin, that would have a significant impact on European growth expectations for 2022. This has led European stocks to plunge the past few weeks.

But the fact is that the main driver of asset prices is not the war in Ukraine, but still the same story as has been told since December 2021, namely inflation and expected interest rate hikes.

Interest rate risk is an important type of risk to be aware of as an investor, as it affects stocks and bonds indiscriminately. That is especially harmful for investors only investing in stocks or using a “balanced” stock-bond portfolio.

We will therefore be taking a closer look at what it is and whether there is anything we can do as investors to protect our wealth and portfolios against it. But let’s begin with a bit of background to lead up to where we are today.

Interest rates in the 2010s

As a response to the negative economic effects of the Covid-19 pandemic, central banks across the globe swiftly and severely decreased steering and repo rates – often to levels close to or even below zero.

Coupled with central bank asset purchases, the aim was to ensure functioning and liquid capital markets and facilitating for as many companies as possible to survive the worst phases of the pandemic.

The overall trend in interest rates have, however, been in a steady decline for four decades already, with key European rates reaching negative territory in the 2010s (ECB in 2014, Bank of Japan in 2016 and Denmark’s Nationalbank in 2012, to name a few).

The Fed has not (yet?) had to turn to negative rates, but is the clearest proxy of the prevailing interest rate trend, as the steering rate topped out at around 20% in March 1980, and bottoming out (again) at 0.25% in 2020. The rate was at the same levels after the 2008 financial crisis, before a temporary increase in 2018 to 2.5%.

Central bank steering rates are not isolated in any way, but these do to a vast extent impact the capital markets. Government Bond yields at different parts of the yield curve are “set” by the market participants as forecasts on where the short term bond yields will be at any time in the future.

For many years, investors and economists have continued to claim that “interest rates and yields can’t fall any lower than they are today”, but every time, that is exactly what has happened. That has meant that the German 10Y bund has also been trading in deeply negative territory, and the American treasury bond with the equivalent tenor traded at a low yield of 0.566 in September 2020.

While the Fed, the ECB, and other central banks control the short-term interest rate, longer-term yields are merely reflections of the market’s future expectations of short-term rates.

As the market is expecting higher rates in the future, which will impact the financing costs of companies and consumers, this is manifested in the yields of bonds with different maturities. Hence, as central banks have been increasingly vocal about hiking rates, in addition to tapering asset purchase programs, this is being reflected in the bond market already now. This also leaks into other assets, such as stocks as well. Hence, rising rates is an investment risk that is hard protect against.

What is interest rate risk?

But let’s take a few steps back and first more carefully answering the question what is interest rate risk?

Interest rate risk is a type of risk that is hard to directly diversify away, as it impacts both fixed-income assets and stocks, albeit in slightly different way.

Bonds are more directly impacted by this risk type, as when rates rise, the price of bonds decline due to opportunity cost of holding a bond.

For example, if a bond is paying you 1.5% per year, and the rate rises to 2%, then it would be more beneficial for the bond investor to sell the first lower-yielding bond and buying a freshly issued one with higher yield that matches the increased rate.

As the market is quite effective, the price of the first bond will fall, so that the effective yield of the bond matches what you would earn with the higher-yielding bond. Hence, as rates rise, bonds will be falling in value.

Rising rates impact bonds with shorter tenors more than bonds with longer tenors. This can be explained by the certainty of expectations. It is easier to predict tomorrow’s weather, than whether the sun will be shining in three weeks’ time. The shorter the timeframe, the higher certainty that the expectations will be true.

This effect is exacerbated by the fact that most central bank communicate their intended rate paths, which is their forecast for the steering rate. However, as it is a forecast rather than a promise, there is still room for the market to decipher what actions the central banks will take even in the near future.

Such forecasts change, and that is what has happened in the beginning of 2022. As the inflation rate has remained elevated, the Fed and ECB have changed course and communicated an intention to raise rates both more and sooner than what the markets previously had expected. This has lead to bonds falling in price.

But longer-term bonds (with 20+ year maturities) have been less affected by the latest rate hiking forecasts, as it appears that the market still believe that further out in the future, rates will have to remain low. One can only make qualified guesses on why that is the case, but common explanations for such expectations include that growth will be harder to achieve with an aging population and decreased globalization, why central banks may not lift its foot from the gas pedal entirely. And with such a high debt-to-GDP ratio as we see among many developed nations today, any meaningful hikes may not be possible even in the intermediate-term without crippling the economy.

As for stocks, the effects of rising rates are more indirect in nature, but they are still considerable.

Firstly, rising rates impact to borrowing costs of companies, as their operations are usually financed by bank loans, bonds, commercial papers, or a combination of the three in addition to the shareholders’ equity. The direct effect is thus that if rates rise, so does the cost of borrowing.

These days, rising yields is particularly problematic for interest expenses, as the so called “Zombie companies” make up a record share of the S&P 500 index. These are companies who only afford to service their debt (amortizations and interest) with their income, but don’t generate any shareholder value. In other words, these are companies with an interest coverage ratio (EBITDA divided by financial expenses) below 1.00x for three years in a row.

It is especially cumbersome that these companies are so great in number despite rates being as low as they are today. If rates were to increase, these companies would encounter even bigger problems. In such case, rising interest expenses would soon grow above its EBITDA, seriously harming the firm’s possibilities to survive for any meaningful time.

Secondly, the price of stocks is a product of equity risk premium over the risk free rate, meaning that interest rates is a crucial component of the expected return of stocks.

As a reminder of the capital asset pricing model (CAPM), the formula for calculating the expected return of the broader stock market, is Expected Return = Risk-Free Rate + Equity Risk Premium. The equity risk premium is usually estimated to be around 4% for blue-chip stocks. The risk-free rate is what an investor could earn by just holding the safest assets available, i.e., government bonds issued by credit-worthy countries.

To translate this to the language of bonds, this expected stock return is the “yield”, and when it rises, the price of the stocks will decline. That is exactly what happens when the risk-free rate component of the model rises.

As a consequence, when the risk-free rate, i.e., the short-term yield, rises, so does the required return of stocks, which has a negative effect of stock prices.

Therefore, when central banks raise rates – or even already when the communicate that they will raise rates – that has a dampening effect on both stock and bond prices.

Can you diversify from interest rate risk?

Now that we have established what interest rate risk is and how it negatively affects the prices of assets, the logical next question is: how can we protect against it?

The disappointing truth is that there is not much that can be done to hedge against future rising rates.

Especially if you are a stock investor or a 60/40 stock/bond investor, rising rates will increase the volatility of your portfolio. Rising rates would significantly impact these in your portfolio, and you’d be in for a certain drawdown.

Looking in the rearview mirror, for the past 40 years, we have been in a falling rate environment ever since 1981, so all-in-all, rising rates have been a negligible issue, as it has always fallen back down after a hike.

But if we instead look ahead, as Fed’s Powell and ECB’s Lagarde are promising rising rates, the undiversified investor is right to worry.

But as holding excessive amount of cash may not be the best idea as the purchasing power is being eroded by inflation (one of the reasons why I am not a follower of Harry Browne’s Permanent Portfolio), we better be looking for protection in the reasons why the rates are rising.

When rates rise, that is one of the few times when the return of cash can be expected to be higher than that of stocks and long-term bonds, as short-term notes are not falling as hard as long-duration assets.

What investments benefit from rising interest rates?

So, let’s back up a bit again. As you know, one of the central banks’ main task is to control inflation (we’ll not review here how good they are at it though…) and their number 1 weapon is the steering rate. When inflation falls below that magic 2% threshold, the central bank lowers its steering rate to spur investment and getting inflation going again, and when inflation is running too hot, the rate is hiked.

That means that to set up your well-diversified portfolio to return in excess of the cash rate also in times when interest rates are rising, you better make sure your portfolio does well in environments that cause rate hikes, that is, in inflationary environments.

Inflation-hedges come in different forms depending on what kind of inflation we are facing (Cost-Push inflation, Demand-Pull inflation, or inflation caused by increased money supply; I will post a short article about this in the near future). A diversified inflation-hedge comes from a combination of commodities (protecting against cost-push inflation), gold (protecting against inflation caused by increased money supply), and inflation-linked bonds/TIPS (protection against demand-pull inflation).

It is hard to protect against the effects of the event of rising rate expectations (especially when we are not interested in trying to predict what goes on in the head of central bank committee members). By always having a broadly diversified portfolio like the All Seasons Portfolio, you will benefit from the environment immediately before cash rates rise, and thus will see more stable returns in your portfolio.

As I have seen this a lot lately, that you could invest in the financial sector, as banks benefit from rising rates, I just want to point out that this is not really true. I will not spend much on this particular question but will just mention that while banks might earn higher interest rates, their funding rates rise correspondingly. In addition, as zombie companies today make up for a record share of the stock market (more than 20%), if rates rise, many of these companies will be forced to file for bankruptcy, with the risk of banks having to write off significant receivables and face capital losses. That is hardly good for a bank’s bottom line.

Investments that benefit from periods just before rates start rising

To illustrate how commodities have benefitted from the rising inflation expectations, I have summarized the performance since January 2020 in the chart below, and compared it with US YoY CPI prints (red line), 5Y Breakeven Inflation Expectations (UST5Y minus USTIP5Y; orange line), the UST2Y market yield (blue line) and the S&P 500 (gold line). During this period Fed’s funds rate has remained zero, so it has not been plotted.

While all of these measures fell in March 2020, both backward looking inflation and forward looking inflation expectations have been climbing steadily for the last two years. This is not at all surprising, driven by a combination of central bank stimulus, supply chain disruptions, and a change in consumer behaviour from buying services to buying more hard things on the back of Covid related restrictions.

This has pushed up commodity prices broadly (both energies and metals). The S&P 500 has seen a similar trend as well, albeit for other reasons, as central banks stimulating a recovery also of economic growth.

But if we zoom in a bit on the last four months, commodities and stocks have begun seeing different development. While stocks began stagnating already in September 2021, commodities kept moving upwards more sustainably. Especially after Fed’s Powell signaled for rate hikes and tighter monetary policy on the December 15 FOMC meeting (red vertical line), interest rate expectations (seen in the 2-year US Treasury Bond) began rising, and stocks began their decent. The UST2Y yield began creeping upwards already before that though (grey area of the chart).

Additionally, as you can read from the last increase of inflation expectations and rising commodity prices even before Russia’s illegal invasion of Ukraine, but that the latter really hockey-sticked.

It is likely, given the continuing rising measured inflation, that commodity prices would have continued to increase steadily even without a war on European soil, but that this has given the commodity prices a preemptive boost.

But all in all, the key take-away from this chart is that while interest rate risk harms some assets (see the stagnation of S&P 500 with the heightened expectation of rising rates), commodities is an asset class that has benefitted before the interest rate risk materialized, and has continued to perform well on the back of both rising measured inflation (CPI; a backward looking measure) and expected future inflation (5Y Breakeven rates).

The All Seasons Portfolio and rising rates

2022 to date shows the benefit of well-diversified and balanced risk parity portfolios. As these types of portfolios include uncorrelated assets that do well in different environments, there will always be at least one asset that gets to show its unique personality, regardless what happens in the world. Through the 2010s, that was stocks and long-term government bonds in a disinflationary environment. Now, it is commodities, gold, and inflation-linked bonds in an inflationary, and possibly slowing growth, environment.

While it is impossible to know with certainty in advance a) what inflation will be in the future and b) what central banks will do, it is important to always have a hedge in place in a portfolio.

The extraordinary events we have already witnessed in the last 2 years – a pandemic and a major war – it shows how vulnerable our world is and what underlying risks there are for economies. That of course has huge impact on financial assets.

As the past two years have been nothing like the “business as usual” times of the prior decade, a growing number of investors have fallen into a false sense of safety, and thereby neglecting due protection.

I am quite glad that I adopted a common-sense type of investing already in late 2019, as I learned about the All Seasons Portfolio strategy and risk parity strategies in general. I turned out to be unbelievably lucky with the timing.

The thing is, that well-diversified portfolios, with built-in protection against all major economic regimes that can be experience, is just common sense.

If you revisit the chart further up, you will see that stocks and commodities have identical returns from the beginning of 2020 until September 2021, but that commodities – an asset class that has been hated throughout the disinflationary 2010s – have since outperformed stocks.

Still, my All Seasons Portfolio has remained stable, and has actually kept growing in value through the war in Ukraine, as I will be showing here below.

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January 2022 Portfolio Update

In January, as discussed in the first part of this post, stocks and bonds rolled over due to the rise in inflation and expectations of rising rates and tapering.

Inflation assets performed much better, with gold, commodities and TIPS being among the winners of the month. Even Bitcoin had a decent month in January.

Looking at my eToro portfolio, the month was not the best one, as my All Seasons Portfolio saw a drawdown of decline of 3.58%. It is important to note that the strategy is not guaranteed to be drawdown proof, but that it is more stable relative to other assets.

As you will see further below in the chart named “3M Portfolio Performance”, you will see that relative to the stock market, and even a balanced 60/40 Portfolio, my All Seasons Portfolio has had a much shallower drawdown in January. While the chart depicts my DEGIRO portfolio, this performance is echoed on eToro as well.

If you are already on eToro, make sure to follow me there too, as I from time to time share brief updates there directly about that particular portfolio. The updates I share on this blog will however remain deeper and more insightful.

Follow me there by finding user Allseasonsport. And feel free to copy my portfolio there with a small amount of your portfolio if you want a more hands-off approach to risk parity investing. I do all my trading there in a systematic and rule-based manner, and already have 16 copiers at the time of writing. I very much like this copy investing functionality, as it makes it easier to follow other people’s strategies, while the investors like myself that are copied have skin in the game as all trades are done with my own money.

As for my “regular” All Seasons Portfolio, the one I am trading on DEGIRO, also saw negative return over the month.

My asset allocation remained in January tilted to benefit from rising inflation and rising rates as my bond allocation has been lower than aimed, and I have been overweight in gold and commodities.

At the time of writing (March 2022), I am looking at reducing the deviation from the aimed allocation in line with my strategic rebalancing rules by rebalancing half way, considering the respective positive and negative trends for these assets.

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Now then, here is the chart I mentioned a bit earlier, which shows that my portfolio has been quite stable in the equity selloff in the last 3 months until end of January.

Moreover, over the last 12 months, my returns are on point with my long-term goal of 6-8% (in line with the long-term annual average of the stock market), but with less than half the volatility.

This is why I am comfortable with levering my portfolio 1.3x on eToro, as the vol is still less than for stocks, but where my returns can get a boost.

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Looking at individual assets, commodities, gold, and Bitcoin were the main drivers on the positive side, with stocks and fixed income trading just slightly down.

Adding also the 3-month chart here below with most assets being fairly grouped upwards.

Lastly, as usual, here is the table of my ETFs and the changes laid out in table form.

ETF	Name	Asset Class	2021-12-31	2022-01-31	Change (portfolio)
UIMB	UBS LFS Bloomberg TIPS 10+ UCI ETF(USD)Ad	TIPS	€564.20	€539.00	-4.47%
DTLE	iShares $ Treasury Bd 20+yr UCITS ETF EUR Hgd Dist	Long-Term Government Bonds	€939.84	€913.44	-2.81%
IGLE	iShares Global Govt Bond UCITS ETF EUR Hedged Dist	Long-Term Government Bonds	€632.10	€620.49	-1.84%
M9SA	Market Access Rogers Int Com Index UCITS ETF	Commodities	€417.78	€457.92	9.61%
4GLD	Xetra-Gold	Gold	€410.59	€410.51	-0.02%
FLXG	Franklin LibertyQ Global Equity SRI UCITS ETF	Stocks	€799.56	€757.94	-5.21%
JPGL	JPM Global Equity Multi-Factor UCITS ETF - USD acc	Stocks	€799.83	€763.05	-4.60%
VOOL	Lyxor S&P 500 VIX Futures Enhcd Roll UCITS ETF A	VIX	€86.42	€28.26	-67.30%
Currency:BTCUSD	Bitcoin XBT	Crypto	€208.10	€169.26	-18.66%
Cash Position			€0.00	€62.00
Total			€4,858.41	€4,721.87	-2.81%

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Thank you yet again for following my blog about risk parity investing and the All Seasons Portfolio. If you haven’t done so already, make sure to subscribe to the newsletter via the form in the page footer, and to drop any comments you may have on the content with the comment section or via email to nicholas@allseasonsportfolio.eu. The greatest value I have received from upkeeping this blog is the fantastic conversations with great people, such as yourselves, about ideas on investing and strategies. Thanks for that!

Remember also to check out the Resources page which I will be filling up with useful tools and resources for managing an All Seasons Portfolio. If you have any suggestions for any particular spreadsheet or tool that you are after, let me know in the comments below and I will see what I can do to have it included.

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We’ll catch up soon for the October update!
Nicholas Ahonen

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