September 2013

Will Rising Rates Sink Risk Parit y?

How a diversified portfolio can continue
to benefit from fixed income
The tides that lifted bond returns for more than two decades are receding.
Improving economic conditions in the US and an easing of the European debt
crisis have rekindled investor fears that interest rates could move significantly
higher and that portfolios with large fixed income allocations could suffer.
We agree that rates are likely to go higher. But we argue that this prospect
does not alter the value of bonds in a diversified portfolio or the attractiveness
of risk parity.
We highlight three points in this paper:
1. H
 igher interest rates are expected by the market and are reflected in steeply
upward-sloping yield curves. If bond yields rise as expected, fixed income
portfolios are likely to perform well.
2. Diversification matters. Fixed income is a vital strategic component of a
diversified portfolio, generating returns that tend to cushion the portfolio in
difficult market environments. Risk parity portfolios are particularly robust in
rising rate environments, because they are balanced to the principal factors
that drive rates upgrowth and inflation.
3. The strong historical performance of risk parity portfolios is not dependent on
falling bond yields.

What are risk parity strategies?

Risk parity strategies vary in terms of implementation, but they have one basic
commonality: building a portfolio based on diversifying sources of risk across a
variety of asset classes.

Ked Hogan, PhD, is Head of the Market

Advantage Group. Contact him at
ked.hogan@blackrock.com

The focus on risk is important, because it is the risk allocation of an asset

not its capital allocationthat determines its impact on the variability of the
portfolios returns. To read more about BlackRocks approach to risk parity
investing, see BlackRocks Risk Factor Investing, Revealed from Fall 2012.

Phil Hodges, PhD, is Head of Research

for the Market Advantage Group. Contact
him at philip.hodges@blackrock.com

The opinions expressed are as of 9/9/13 and are subject to change.

FOR USE WITH INSTITUTIONAL AND PROFESSIONAL INVESTORS ONLYPROPRIETARY AND CONFIDENTIAL

1. Higher rates are expected by

the market

What does this mean? Rates can rise by up to 60 bps over the
next year and bondholders will still earn a reasonable return;
only rate rises notably faster and higher than expected (above
the dotted lines in Figure 2) will start to erode bond returns.

Bond yields have steadily declined over the last 30 years

(Figure 1), including a large drop in response to the global
financial crisis. Investors have once again started to call the
bottom in rates.

Bond investors do not necessarily suffer in the face of

rising rates. The critical factor is the extent to which the
rise in rates is consistent with expectations. To illustrate
this, we consider three scenariosrates rise in line with
expectations, rates rise beyond expectations, and rates
fall. We infer expectations from the forward curve,1 and
we decompose the returns for each calendar year since
1972 (the longest time period for which US forward rates
are available) into three regimes:

During May and June of 2013, interest rates spiked upward

because of expectations of rates moving up, as the Federal
Reserve unwinds its quantitative easing program (so-called
taper talk). There was no formal increase in benchmark rates
by the Fed, just the prospect of one in the future.
The interest rate yield curve is now steeper than normal
because the bond market already reflects the view that
interest rates are going up.

1. Orderly increase in rates (rates rise by no more than

75 bps above expectations),

Figure 2 shows the path of 10-year interest rates in the US,

Germany and the UK over the previous five years, along with
the markets expectations of interest rates over the next five
years (derived from the forward curve). Because current bond
prices incorporate these expected rate rises, the bond
market has already priced in US rates rising above 4.5% in
five years (mid 2018), and rising a full 60 bps to 3.3% a year
from now (mid 2014).

2. Disorderly increase in rates (rates rise by more than

75 bps above expectations), or
3. All other (falling interest rates).

Figure 1: Bond yields have been in a long downward trend (US 10-year Treasury yield)

10-YEAR YIELDS (PERCENT)

20

15

10

0
1930

1940

1950

1960

1970

1980

1990

2000

2010

Sources: Ibbotson, US Federal Reserve and BlackRock, as of 6/1/13.

Since the global financial crisis, interest rates have been driven to historic lows by a combination of

20

extraordinary monetary policy and economic uncertainty.

15

1 Unexpected yield changes are defined as the difference between the current 10-year par yield and the 1y10y forward rate one year
ago. The series is then demeaned to remove the term premium.

10

[2]

Figure6 2: The market expects interest rates TO RISE

(HISTORIC AND IMPLIED FUTURE 10-YEAR INTEREST RATES, BASED ON BOND PRICES 8/31/13)
10-YEAR RATES (PERCENT)

5
4
3
2
1
0
2008

2009
US

2010

2011

Germany

2012

2013

2014

US (market implied)

UK

2015

2016

Germany (market implied)

2017

2018

UK (market implied)

Source: BlackRock, as of 8/31/13.

Bond prices now incorporate expected rate rises over the next five years in the US, Germany and the UK.
6

5
In Figure 3, we calculate the average returns of four
4
portfoliosall bonds, all equities, 60% equities / 40%
3 risk parity strategy2for each of these
bonds, and a simple
three regimes. (The2 GSCI Commodity Index is also listed
because of its inclusion
in the risk parity strategy.3)
1
0
The table shows average
annual returns (in excess of the
risk-free rate) for these
UKportfolios in each interest rate
environment. As expected, bonds generate their best
returns when interest rates decline; they generate their worst
returns when rates6rise considerably more than expected.

But importantly, they still generate positive returns above

cash when rates rise in an orderly way.
More striking is the performance of our simple risk parity
portfolio across these three regimes. This portfolio
generates its weakest returns in a disorderly rising interest
rate regime, but not much weaker than a traditional 60/40
portfolio. In the other regimes, it outperforms the 60/40
portfolio. All in all, the risk parity portfolio produces
reasonable returns across different interest rate regimes
which is exactly what it was designed to do.

5
4
Figure 3: A simple
risk parity portfolio outperforms traditional portfolios
(Average returns
for three regimes since 1972)
3
Average returns in regime 1:
Orderly increase in rates
(<75 bps above expectations)
Bonds
Equities
Commodities (GSCI)

0.2%

Average returns in regime 2:

Disorderly increase in rates
(>75 bps above expectations)
-3.9%

Average returns in regime 3:

Falling rates
7.7%

9.2%

3.1%

7.4%

17.5%

14.1%

-0.9%

60% equities / 40% bonds

5.5%

0.2%

7.5%

Risk parity strategy

8.6%

-0.3%

10.8%

14

21

Years in sample (19722012)

Sources: US Federal Reserve, Ibbotson, Datastream, and Bloomberg, January 1972 to December 2012. Bonds: Ibbotson Intermediate-Term Treasury Index. Equities: S&P 500 Total Return
Index. Commodities: GSCI Commodity Index Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Past performance is not indicative of future returns.

2 The simple risk parity strategy is a 40/115/30 allocation of the S&P 500, the Ibbotson Intermediate-Term Treasury Index, and the
GSCI Commodity Index. It targets a risk level of 10% and equal risk allocation among all three components, assuming zero
correlations at volatilities of 15%/5%/20%. Thirty percent of capital is invested in T-bills to meet margin calls. We assume a 50-bps
spread over T-bills for derivatives financing.
3 Note that the average returns for commodities may be somewhat anomalous, given the very strong historical performance of the 1970s.
We do not expect commodities to have such high returns going forward.
[3]

2. Bonds are a vital strategic

component of diversified portfolios
All well-balanced portfolios have some exposure to bonds.
Interest rate exposure is a key portfolio diversifierbonds
provide an important hedge against environments in which
risky assets perform poorly. Notably, Treasury returns tend
to be strongest when equities produce their most negative
returns (Figure 4).
It is also essential to diversify among different types of
interest rate exposure, because different exposures pay
off in different economic environments (Figure 5). Nominal
bonds, for example, tend to hedge against periods of
deflationary low growth, while inflation-linked bonds (real
bonds) provide additional defense against inflationary low
growth (stagflation).

Figure 4: Interest rate exposure helps to

cushion portfolios in the case of bad returns
from equities (Monthly returns of US
Treasuries sortED by US equity returns)

US TREASURY EXCESS
RETURN (PERCENT)

0.6

In a rising rates environment, the key is to identify the factors

driving rate increases, because these factors influence how
each asset class will be impacted and, by extension, how the
whole portfolio will perform. Rate rises are usually
accompanied by either economic growth or inflation. While
surprises in either could be negative for bond portfolios, they
will substantially benefit growth- and/or inflation-oriented
assets. Risk parity portfolios, which balance exposures
across different types of risk, are particularly well
constructed to be robust across these environments.
However, when rate increases are driven not by growth or
inflation but by central bank activity or increasing sovereign
credit risk, almost all portfolios perform poorly. We observed
this in May and June of 2013. The best defense in this
environment is to reduce or hedge exposures (de-risk),
something that risk parity strategieswhich tend to have
variable levels of exposure and leverageare actually better
equipped to do than traditional portfolios.

Figure 5: Balancing exposures to different

types of bonds allows investors to
generate returns in different economic
environments (Average returns by asset
class for different economic environments)

0.5

Growth

Deflationary
falling
growth

Inflationary
falling
growth

Nominal
bonds

0.6%

5.3%

2.8%

Real bonds

6.2%

-0.3%

4.6%

Equities

11.1%

6.7%

-5.1%

0.4
0.3
0.2
0.1
0
<4%

4% to 0%

0% to 4%

>4%

US EQUITY EXCESS RETURN

Source: BlackRock, January 1985 to July 2013. Indices include the S&P 500,
BofA Merrill Lynch U.S. Treasury Master Index, and LIBOR USD 1 Month.

Core fixed income tends to generate its

Sources: Datastream, Ibbotson and Bloomberg, as of 8/1/13. Nominal

bonds: Ibbotson Intermediate-Term Treasury Index, 1/727/13. Real bonds:
Barclays US Inflation Linked Bond Index, 3/977/13. Equities: S&P 500
Total Return Index, 1/727/13. Cash: One-month US Treasury Bills. Note:
Growth rising/falling is defined by a 3-month increase/decrease in the US
ISM Manufacturing Index. Inflation rising/falling is defined by a 3-month
increase/decrease in the 12-month percentage change of the US PCE index.

strongest returns when equities generate

their worst returns, helping diversified

Investors should consider diversifying

portfolios to generate much more consistent

their fixed income exposure, for more

returns through time.

consistent returns.

[4]

We can show that the strong performance of risk parity

strategies is not dependent on falling interest rates, by
calculating the boost from falling interest rates and entirely
removing it from the strategy performance.
We do this by simulating returns of the risk parity strategy
used in Figure 3 from January 1988 to January 2013. During
this sample period, the 10-year Treasury rate declined from
8.7% to 1.9%.4 We make the reasonable long-term assumption
that investors typically expect yields to remain at current
levels and then we remove all of the windfall gains from
unexpected falls in interest rates from our fixed income
returns.5 This process reduces the observed annual returns of
inflation-linked bonds by 2.2% and nominal government
bonds by 1.2%.
Even after removing all of these gains from falling interest
rates, the risk parity portfolio dramatically outperforms both
a 60/40 portfolio and a portfolio of developed market
equities, on an absolute and risk-adjusted returns basis
(Figure 6).
This points to an essential principle of risk parity investing
a portfolio balanced across diversified risk premia is resilient
to a variety of economic risks and is not dependent on any
single economic outcome (such as falling interest rates or
strong economic growth) to generate returns. Unexpected
losses in any single risk premium can be just as likely as
unexpected gains. And while few investors can consistently
forecast these, we can all make better use of sources of
return beyond the equity risk premium and fully exploit the
benefits of diversification. In an uncertain world, the risk
parity approach seems to be a much less risky proposition.

Figure 6: Risk parity outperforms traditional

portfolios, even after removing the
benefits from falling interest rates
Annualized return

Sharpe ratio

Unadjusted

Adjusted
to remove
impact of
falling rates

Unadjusted

Adjusted
to remove
impact of
falling rates

Risk
parity
strategy

11.1%

9.5%

0.74

0.57

60/40
portfolio

7.2%

6.8%

0.40

0.35

MSCI
World
Index

7.4%

7.4%

0.24

0.24

0.8

SHARPE RATIO

3. Risk parity is not dependent on

falling bond yields

0.6
0.4
0.2
0
Risk Parity Strategy

Unadjusted

60/40

MSCI World

Adjusted (removed capital gains from falling yields)

Source: BlackRock, 1/881/13. The 60/40 portfolio is 60% MSCI World, 40%
Barclays US Aggregate Index. The risk parity strategy is a 40/115/30 allocation of
the S&P 500, the Ibbotson Intermediate-Term Treasury Index, and the GSCI
Commodity Index. It targets a risk level of 10% and equal risk allocation among
all three components, assuming zero correlations at volatilities of 15%/5%/20%.
Thirty percent of capital is invested in T-bills to meet margin calls. We assume a
50-bps spread over T-bills for derivatives financing. Index performance is shown
for illustrative purposes only and is not a guide to the future performance of any
BlackRock fund or strategy. You cannot invest directly in an index.

4 It is unlikely that, in 1988, investors expected such a consistent fall in yields; therefore, at least some of the observed strong returns
from bonds were due to windfall gains, not a priced term risk premium.
5 We do this by subtracting the yield at the end of the period from the yield at the beginning of the period, multiplying this by the
average duration of the bond, and then removing this total capital gain equally across all the months of the sample.
[5]

Balancing returns across all

risk premia
Asking whether investors should pare back exposures to
fixed income when interest rates are expected to rise
focuses on the wrong question. If the market expects
interest rates to rise, then this information has already
been priced into bond yields, and curves will be steepas
they are now. The market expects rates to rise, and we do
too. Selling fixed income in todays market implies the
belief that rates will rise by more than 60 bps over the next
year, and by more than 175 bps over the next five years.
We do not take that view: investors simply do not know
with certainty where interest rates will be, and when.
What we do know, however, is that bonds still fill an
important role. They are not in portfolios solely to generate

[6]

returns, but also to hedge environments in which other

assets perform poorly. All portfolios may benefit from some
allocation to bonds in order to reduce risk, and risk parity
portfolios are particularly well constructed to be robust in
different environments. This is why we believe risk parity
which balances exposures to growth and inflationis well
positioned for a period of rising rates.
For investors seeking consistent growth, we recommend
balancing exposures across a diverse array of risks that
generate returns in different environments. Interest rate
risk is just one of several sources of return, and we have
demonstrated that risk parity is not dependent on it. Risk
parity portfolios have shown resilience to a multitude of
economic environments in the past, and we expect them
to continue to do so.

In the US this material is for institutional investors only. In the EU issued by BlackRock
Investment Management (UK) Limited (authorised and regulated by the Financial Conduct
Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered
in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are
usually recorded. BlackRock is a trading name of BlackRock Investment Management
(UK) Limited. In Hong Kong, the information provided is issued by BlackRock (Hong Kong)
Limited and is only for distribution to professional investors (as defined in the Securities
and Futures Ordinances (Cap. 571 of the laws of Hong Kong)) and should not be relied
upon by any other persons. In Singapore, this is issued by BlackRock (Singapore) Limited
(company registration number: 200010143N) for institutional investors only. For distribution
in Korea for Professional Investors only (or professional clients, as such term may apply
in local jurisdictions).
For distribution in EMEA and Korea for Professional Investors only (or professional clients,
as such term may apply in relevant jurisdictions). In Taiwan for distribution to Institutional
Investors only and should not be relied upon by any other persons. Independently operated
by BlackRock Investment Management (Taiwan) Limited. Address: 28/F, No. 95, Tun
Hwa South Road, Section 2, Taipei 106, Taiwan. Tel: (02)23261600. In Japan, not for use
with individual investors. In Canada, this material is intended for permitted clients only. This
material is being distributed/issued in Australia and New Zealand by BlackRock Financial
Management, Inc. (BFM), which is a United States domiciled entity and is exempted
under ASIC CO 03/1100 from the requirement to hold an Australian Financial Services
License and is regulated by the Securities and Exchange Commission under US laws which
differ from Australian laws. In Australia this document is only distributed to wholesale and
professional investors within the meaning of the Corporations Act 2001. In New Zealand,

this document is not to be distributed to retail clients. BFM believes that the information
in this document is correct at the time of compilation, but no warranty of accuracy or
reliability is given and no responsibility arising in any other way for errors and omissions
(including responsibility to any person by reason of negligence) is accepted by BFM,
its officers, employees or agents.
In Latin America, for Institutional and Professional Investors only. This material is solely
for educational purposes and does not constitute investment advice, or an offer or
a solicitation to sell or a solicitation of an offer to buy any shares of any funds (nor
shall any such shares be offered or sold to any person) in any jurisdiction within
Latin America in which such an offer, solicitation, purchase or sale would be unlawful
under the securities laws of that jurisdiction. If any funds are mentioned or inferred to in
this material, it is possible that some or all of the funds have not been registered with the
securities regulator of Brazil, Chile, Colombia, Mexico, Peru or any other securities regulator
in any Latin American country, and thus, might not be publicly offered within any such country.
The securities regulators of such countries have not confirmed the accuracy of any information
contained herein. No information discussed herein can be provided to the general public in
Latin America.
2013 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of
BlackRock, Inc. 5746_THK_9/13
for institutional use onlynot for public distribution

BLK-0966
[7]

To learn more about risk parity investing, please contact your BlackRock account manager.

[8]