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The Implications of a Higher Risk-Free Rate on the Equity Risk Premium

Does a higher cash rate tide lift, hurt or have no significant impact on asset returns?

To combat rising inflation, in April 2022, the Federal Reserve began raising the Fed funds rate from its target of 0%—0.25% to 5.25 - 5.50%, pushing one-month Treasury bills (the benchmark for risk-free interest rates) to 5.50%.

While all crystal balls are cloudy when it comes to future interest rates, it seems likely that the level of rates will be significantly higher (at least for quite some time) than it was from October 2008 through March of 2022 (when the fed funds rate was operating with a zero-interest rate policy, referred to as ZIRP).

While the stock and bond markets are expecting that rates will fall, they will likely remain well above the ZIRP rate regime we experienced over the period October 2008 - March 2022. And this is likely the case around the globe. For example, the markets expect the federal funds rate to average 320 basis points (bps) higher in the 10 years going forward than the roughly 14 years prior to the Federal Reserve began raising interest rates in March 2022. The equivalent gap is 300 bps for the eurozone and 380 bps for the United Kingdom. What, if any, are the implications for asset allocation? Does a higher cash rate tide lift, hurt or have no significant impact on all asset returns?

AQR’s Thomas Maloney sought to answer these questions in his paper “Honey, the Fed Shrunk the Equity Premium: Asset Allocation in a Higher-Rate World,” published in the April 2024 issue of The Journal of Portfolio Management. To test return sensitivities, he used three different methods to define lower and higher rate regimes:

  • Full-sample categorization: He divided the sample into rates above and below the median. While this method was simple and intuitive, it tended to result in a few prolonged episodes of each environment and, therefore, a small number of independent observations.
  • Rolling categorization (trailing window): He compared each observation to the trailing five-year period to detrend the series and identify more episodes of higher and lower rates.
  • Rolling categorization (centered window): He compared each observation to the five-year period centered upon it. The centered method was used because, unlike a trailing window, it was not biased toward periods of rising rates—and Maloney wanted to test sensitivity to levels, not changes.

Maloney’s data set covered the period 1926-2023 and U.S. equity returns, U.S. Treasury bond returns, and U.S. corporate credit returns. Here is a summary of his key findings:

All three asset classes delivered positive premiums in both high and low regimes over a range of horizons. However, premiums were not constant. Risk premiums were smaller when starting cash rates were higher for all three asset classes and at all horizons—and most dramatically for equities.

Bonds earned somewhat higher total returns in higher rate regimes, though with slimmer risk premiums.

While the real returns on equity were lower in the higher rate regime, the real returns to Treasurys and cash were significantly higher.  

Private, illiquid assets (real estate and private equity) exhibited similar patterns as equities (positive but lower nominal and real returns in higher rate regimes), whereas liquid alternatives—which tend to maintain substantial cash holdings—delivered similar excess returns in higher and lower rate environments.

If all assets’ expected returns moved in parallel with cash rates, higher cash rates would make for easier investing. But history leads us to expect different responses from different asset classes, with cash-plus liquid alternatives gaining a relative advantage. The lower returns to equities in higher rate regimes occurred despite their lower valuations during such periods. Equity returns were also lower in higher rate regimes even though when starting interest rates were high, they were more likely to fall than to rise further—on average, starting from a higher rate regime, the T-bill rate fell 27 bps over the next 12 months, and 73 bps over the next 36 months. Starting from a lower rate regime, the corresponding average changes were increases of 29 bps and 63 bps, respectively.

An explanation for the lower real returns to equities in higher interest rate regimes (despite lower valuations and the greater likelihood that rates would fall) is that over the 1926–2023 period, annualized real earnings-per-share (EPS) growth was 11% when starting from a low-interest rate but only 1% when starting from a high-interest rate (arithmetic means). The geometric means were 5.8% and -1.1%, respectively. “Intuitively, it is low interest rates that stimulate demand and facilitate business financing and expansion.”

Maloney next considered if some investments offered more resilient premiums in the face of higher interest rates. To answer this, he examined a shorter, broader data set, beginning in 1990, so that he could add real estate, private equity, and liquid alternatives—choosing equity market-neutral and trend-following strategies as represented by hedge fund indexes because both have exhibited near-zero equity beta over the long term, and both tend to maintain large cash holdings. He found that they were able to generate comparable excess returns in both environments. Thus, their average total returns were substantially higher in the higher rate regimes.

His findings led Maloney to conclude: “In a higher-rate world that investors haven’t seen for many years, diversification away from equities may prove to be especially valuable.” He added that during the zero-rate regime of the 2010s, many investors with return hurdles to meet were “forced” to significantly increase their allocation to risky assets. Similarly, with the empirical evidence that higher rate regimes have correlated with lower premiums to not only equities but real estate and private equity as well, liquid alternatives acquire a relative advantage over other return-seeking assets in higher rate regimes, delivering cash-plus returns historically. He added: “Equities and illiquid alternatives have tended to underperform when cash rates are higher. Bonds have done a better job of passing the cash rate on to investors, and liquid alternatives have done best of all.”

Investor Takeaways

While equities and bonds have, on average, provided positive returns in both higher and lower interest rate regimes, their risk premiums have tended to be lower in higher rate regimes, with implications for future expected returns and asset allocation decisions.

Liquid alternatives (which today have significantly lower expense ratios than they did 20 years ago when they were generally available only in the form of hedge funds with typical 2/20 fee structures) have provided a relative advantage over other risk assets in higher rate regimes. In addition, they can provide significant diversification benefits, as they can add unique sources of risk with low correlation to traditional stock and bond portfolios.

In addition to daily liquid, market-neutral and trend-following funds, two relatively new alternatives could be considered. The first is reinsurance, which also provides a unique source of risk (hurricanes and earthquakes don’t generally impact equity and bond markets, and bear markets in those assets don’t cause hurricanes or earthquakes) and benefits from higher rate regimes, as reinsurance funds hold their collateral in the form of Treasury bills. Reinsurance funds can either be daily liquid (as can be the case with catastrophe bond funds) or semiliquid (in the case of interval funds, which provide quarterly liquidity, typically a minimum of 5% per quarter). The second is private, senior, secured loans backed by private equity firms available in semiliquid interval funds. Unlike corporate bonds, these loans are all floating rates. Thus, their yields benefit from rising interest rates. 


Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich Your Future.

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