Real Interest Rate Shocks and Portfolio Strategy

Abstract

Fluctuations in real interest rates affect every aspect of an investment program, including the present value of the liability, as well as the returns on each asset class. We review the history and causes of real interest rate fluctuations using a nonmathematical very simple macro model, then assess the risks to each major asset class (and also to liabilities) from likely changes in the real rate. The objective is to help investors defend their portfolios against this important risk. An appendix provides deep history, showing that real interest rates have declined over very long periods of time as markets and political institutions have become more developed.

TOPICS: Real estate, commodities, real assets/alternative investments/private equity, currency, private equity

Key Findings

• • Rapidly rising real rates pose a substantial risk to the whole portfolio, through both fixed income and equity assets. Although the risk posed to fixed income is direct and mechanical, the risk posed to equities and alternative assets is complex and subtle.

• • This asset-side risk may be offset, to a greater or lesser degree, depending on the real interest rate duration of the liability, by a decrease in liability valuation due to rising real rates (again, depending on duration).

• • The risk of a decline in real interest rates comes from the opportunity-cost of being out of a rising bond fixmarket. Many investors, leery of the potential for rising rates, have shortened the duration of their holdings and would not participate to a satisfactory extent if a bond rally were to occur due to rates falling further.