Interest Rates and Expected Returns

Many people are questioning whether they should stay in fixed income or branch out to other strategies with higher expected returns, due to low interest rates. The following discusses viewing expected returns between investment strategies. The low interest rate environment has many people wondering about using their fixed income allocation for other strategies, such as investing in dividend paying stocks or stretching for yield by taking credit risk. We have also seen popular press pieces in The Wall Street Journal and elsewhere that suggest some of these same ideas. The analysis we have seen, however, has at least one fatal flaw: It fails to recognize the fundamental link between expected returns on fixed income investments and expected returns on all other investment strategies. There’s no doubt interest-rate levels are historically low right now.

As of September 30, the five-year Treasury rate was 1.32 percent. Over the past 10 years, the average yield of the five-year Treasury has been about 3.6 percent. In financial academia, the expected return on any investment is the risk-free rate of return plus a risk premium (or premiums). By this logic, when the risk-free rate of return is relatively low, all else equal, the expected return on any investment is relatively low. For example, one simple model for the expected return on the overall U.S. stock market is the current Treasury bill rate plus the historical equity risk premium — the historical amount by which U.S. stocks have outperformed Treasury bills.

Using this methodology, we graphed the annual expected return of the overall U.S. stock market at the end of each month for the period July 2001 through August 2010. We assumed the expected annual return was the one-month Treasury bill rate at the end of that month plus the historical annual equity risk premium. While this is a relatively simple methodology, it does illustrate our main point.
Under this setup, it is clear that expected equity returns are higher when interest rates are higher, and vice versa. The only way this would not be true is if you believed market prices were wrong or risk premiums were changing over time. We believe market prices are generally fair. If risk premiums are relatively high (low), that does not necessarily mean that you should increase (decrease) exposure to an asset class, because this means you are increasing (decreasing) overall portfolio risk. Therefore, the best approach is to recognize the fundamental link between interest rates and expected returns on other investments and maintain a disciplined, well-diversified asset allocation through all market conditions.

Copyright © 2010, Buckingham Family of Financial Services
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