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ITC Holdings’ (ITC) CEO Joseph Welch on Q1 2016 Results – Earnings Call Transcript

ITC Holdings Corp. (NYSE: ITC ) Q1 2016 Earnings Conference Call April 28, 2016 10:00 ET Executives Stephanie Amaimo – Director, IR Joseph Welch – Chairman, President & CEO Rejji Hayes – SVP & CFO Analysts Julien Dumoulin-Smith – UBS Caroline Bone – Deutsche Bank Praful Mehta – Citigroup Operator Good day, ladies and gentlemen, and welcome to the ITC Holdings Corp First Quarter Conference Call and Webcast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today’s conference, Ms. Stephanie Amaimo. Ma’am, you may begin. Stephanie Amaimo Good morning, everyone and thank you for joining us for ITC’s 2016 first quarter earnings conference call. Joining me on today’s call are Joseph Welch, Chairman, President and CEO of ITC; and Rejji Hayes, our Senior Vice President and CFO. This morning we issued a press release summarizing our results for the first quarter ended March 31, 2016. We expect to file our Form 10-Q with the Securities and Exchange Commission today. Before we begin, I would like to make everyone aware of the cautionary language contained in the Safe Harbor statement. Certain statements made during today’s call that are not historical facts such as those regarding our future plans, objectives, and expected performance reflect forward-looking statements under federal securities laws. While we believe these statements are reasonable, they are subject to various risks and uncertainties and actual results may differ materially from our projections and expectations. These risks and uncertainties are disclosed in our reports filed with the SEC such as our periodic reports on forms 10-K and 10-Q and our other SEC filings. You should consider these risk factors when evaluating our forward-looking statements. Our forward-looking statements represent our outlook only as of today and we disclaim any obligation to update these statements except as may be required by law. A reconciliation of the non-GAAP financial measures discussed on today’s call is available on the Investor Relations page of our website. I will now turn the call over to Joe Welch. Joseph Welch Thank you, Stephanie and good morning everyone. I’m pleased to report that we’re off to a solid start in 2016. We continue to deliver operational excellence to our customers and superior growth to our shareholders while concurrently focusing on the Fortis acquisition of ITC. On the operational front, system performance for the first quarter of 2016 aligned with our historical track record with good performance across the operating companies and minimal impacts to the system despite several spring storms in March. In addition, our capital projects and maintenance programs were off to a good start for the year. Many reliability, system capacity and customer interconnection projects are in process across all of our operating companies and progressing on schedule. One notable project in Detroit that we work to complete it in February is our portion of the new Temple substation which will support the load requirements for the new Red Wings Stadium. With respect to our development efforts, we continue to advance the new Covert project, which is scheduled to go into service later this year along with preparations and certifications to operate in PJM. We are also continuing to negotiate bilateral contracts with shippers on the Lake Erie Connector project. As we highlighted on our last call, the MISO Transmission owners filed their updated testimony on January 29, in the second base ROE complaint and have since held various hearings and briefings during the last several months as part of their most recent procedural schedule. And initial decision in the second base ROE complaint is expected from the Administrative Law Judge by the end of June. While final decisions from the FERC Commission aren’t expected until late 2016 and the first half of 2017 for the first and second complaints respectively, we remain confident that FERC will continue to support their historical policies given the significant investment requirements necessary to modernize the electrical infrastructure in the U.S. As for other regulatory matters, on March 11, FERC issued two orders concerning ITC Midwest. In summary, in its orders on the final and the formal challenge of ITC Midwest 2015 formula rates in its orders conditionally accepting the Bent Tree facility service agreement, FERC concluded that ITC Midwest’s decision to elect out of bonus depreciation wasn’t prudent. As a result, FERC has required ITC Midwest to simulate the effects of bonus depreciation that is to calculate generally applicable transmission rates and its charges under a specific agreement as though the company actually had taken bonus depreciation for facilities placed into service in 2015. In response to FERC’s order, on April 11, ITC Midwest filed request for rehearing on both orders, essentially asking FERC to reconsider and reverse its decisions. To the extent that FERC decided not to reverse its orders on the formal challenge, ITC Midwest also asked FERC to modify the date for implementation of the order on the formal challenge so that ITC Midwest is able to maintain compliance with the new tax law requirements. As we wait FERC’s response to our request for rehearing, we’ve taken steps to comply with these orders and have recorded the applicable bonus depreciation impacts during the first quarter as well as the necessary compliance filings on the Bent Tree facility service agreement. Subsequently, we’ve since received a similar challenges at METC from CMS, and are in the process of evaluating the next steps. That said, although we expect these proceedings to take some time to be resolved, we plan to elect bonus depreciation across all our companies for the 2015 and 2016 tax years. With respect to the Fortis transaction, Fortis and ITC have worked diligently to advance the transaction. The most material news since our last call – last week’s announcement of Fortis entering into a definitive agreement with GIC to acquire 19.9% equity interest in ITC for over $1.2 billion in cash upon closing the transaction. Needless to say, we are delighted with this outcome, as well as a well-respected long-term investor with over $100 billion in assets under management and strong track record of investing in North America infrastructure, GIC will be a great investment partner for Fortis and co-owners of ITC. With the minority investor secured, we can now proceed with other key milestones in the transaction, including the remaining State and Federal regulatory filings and the shareholder votes for both Fortis at ITC. Overall, the transaction continues to progress as planned, and we expect to close in the late 2016. Although it’s been a busy start to the year, we look forward to another strong year both operationally to the benefits of our customers, and financially by creating long-term value for the shareholders. I will now turn the call over to Rejji to elaborate on our first quarter 2016 financial results. Rejji Hayes Thank you, Joe, and good morning, everyone. For the three months ended March 31, 2016, ITC reported net income of $64.2 million or $0.42 per diluted share as compared to reported net income of $67.1 million or $0.43 per diluted share for the first quarter of 2015. Operating earnings for the first quarter of 2016 were $84.5 million or $0.55 per diluted share compared to $73.1 million or $0.47 per diluted share for the first quarter of 2015. Operating earnings are reported on a basis consistent with how we have provided our guidance for the year and exclude the following items. First, they exclude regulatory charges of approximately $1.1 million or $0.01 per share for the first quarter of 2015. The 2015 charges relate to management’s decision to write-off abandoned costs associated with a project of ITC Transmission. Second, operating earnings exclude the estimated refund liability associated with the MISO base ROE, which totaled $11.5 million or $0.07 per diluted share for the first quarter of 2016 and $4.8 million or $0.03 per diluted share for the first quarter of 2015. It is possible that upon the ultimate resolution of this matter we may be required to pay refunds beyond what has been record to-date. We will continue to assess this matter and we’ll provide updates as necessary. Lastly, they exclude after tax expenses associated with the Fortis transaction of approximately $8.7 million or $0.06 per diluted share for the first quarter 2016. Operating earnings for the three months ended March 31, 2016 increased by approximately $11.4 million or $0.08 per diluted share of the comparable period in 2015, primarily due to higher income associated with increased rate base at our operating companies coupled with lower non-recoverable bonus payments associated with the V-Plan project in the first quarter of 2016 compared to the same period in 2015. These beneficial factors are partially offset by the impact of electing bonus depreciation, as Joe highlighted, at all of our operating subsidiaries. For the three months ended March 31, 2016, we invested $176.6 million in capital projects at our operating companies, including $41.1 million at ITC Transmission, $47 million of METC, $74.8 million at ITC Midwest and $13.7 million at ITC Great Plains. With respect to our financing liquidity initiatives on April 26, 2016, we executed a 30-year debt issuance at METC, the $200 million of senior secured notes were priced at 3.9% and the proceeds will be used to refinance an unsecured three-year term loan at METC. As we’ve underscored in the past, management remains committed to sustaining our strong financial position and solid investment grade credit ratings. As such, we are pleased to report that on April 15, Moody’s affirmed the issue ratings in outlook of ITC and its regulated operating subsidiaries. From a liquidity perspective, as of March 31, 2016, we have readily available liquidity of approximately $775 million, which consists of roughly $8 million of cash on hand and $767 million of net undrawn capacity on our revolving credit facilities. For the three months ended March 31, 2016, we reported operating cash flows of approximately $88 million, which reflects an increase of approximately $21 million from the first quarter 2015. It’s also worth noting that on April 7, 2016, we successfully amended all of our revolving credit facilities with unanimous support from our syndicate of lenders to allow for consummation of the transactions. As a result, we will be able to maintain the revolving credit facilities and the amounts under the revolving credit facilities close. In closing, we are well positioned to execute on our plans in 2016, including the Fortis acquisition of ITC, to benefit the customers and shareholders. Our continued solid performance in the first quarter serves as an important foundation for these efforts. At this time, we’d like to open the call to address questions from the investment community. Question-and-Answer Session Operator [Operator Instructions] And our first question comes from Julien Dumoulin-Smith from UBS. Your line is now open. Julien Dumoulin-Smith Hi, good morning. Joseph Welch Good morning, Julien. Julien Dumoulin-Smith So quick question here on the independent side. Obviously, we’ve got the GIC involved now as a JV partner. Would you expect to be able to keep that on a prospective basis here? Joseph Welch I think that’s a question you ought to ask GIC. The thing is that, as far as we’re concerned, this is – Fortis’ and GIC’s filing and you ITC and its shareholders were held harmless to that decision. Julien Dumoulin-Smith Got it. And then subsequently, you’ve commented in the past on FERC Order 1000, I’d be curious to get your latest thoughts on the SPP process. Obviously that had certain issues about allocations of points on the technical basis. I’d be curious to get your reaction and any broader implication? Joseph Welch No, I think that the SPP’s decision probably fits into the same line as the decisions that’s taken place in PJM, for instance that they awarded the points, I find it interesting that – from my standpoint, they’ve eliminated a lot of people based on conductor size and conductor design and we feel strongly, in our case, that our conductor sizing and design was 110% appropriate. But I could tell you this that on the whole process of a line that size and the amount of magnitude from an investment perspective, there was more money spent on bidding on it and more money spent on evaluating it than the whole line was worth. Julien Dumoulin-Smith Intriguing data point itself. And lastly, just turning back to bonus depreciation with the CMS complaint out there, I’d be curious how do you intend to treat results for this year given METC and actually potentially for the balance of the portfolio? Rejji Hayes Yes, Julien this is Rejji. Joe and I highlighted, we have assumed the election of bonus depreciation, both for the 2015 tax year as well as the 2016 tax year. And so as our Q is filed later today, you’ll see the details around that. It is flowing through the financials you see in the earnings release that hit the tape this morning and the estimate on a pre-tax basis for Q1 is about $5.4 million after-tax, about $3.2 million. And you can assume over the course of 2016, you’re probably just under $10 million and that’s for the full estimate for 2016 across all of the operating companies. So we are erring on the side of conservatism in our financials, but needless to say, we obviously requested a rehearing with the FERC on the IP&L matter. So we’ll see where we go from there. Julien Dumoulin-Smith Okay, great. Thank you. Rejji Hayes Thank you. Operator And our next question comes from Caroline Bone from Deutsche Bank. Your line is now open. Caroline Bone Good morning. Just a follow-up on that bonus depreciation question. Thank you so much for the details on the impacts for the quarter and the full year, but I was just wondering if you could comment a little bit about how this might impact your more long-term growth expectations? Joseph Welch It really, when I look at growth, I don’t look at growth quite the same way you do, we’re going to be growing at the same rate that we’ve always grown, when you look at the earnings and the bonus depreciation, but the fact of the matter is that the bonus depreciation, if you elect it and generates a lot of cash and that gives us the ability to start to invest in other areas. Rejji Hayes Yes, exactly right. The only thing I would add to that, Caroline, is it clearly you’re going to have a financial impact on your net earnings, we talked of the 2016 impact and as I’m sure you well know and which the election works, it flows through our tariff as an increase in deferred tax liabilities that reduces rate base and you basically have to wear that financial impact for about 15 years. And so you do work for some time, but as Joe highlighted, clearly we’re still going to be investing in the system and trying to obviously improve the system to the benefit of customers. Caroline Bone All right. So I guess, I mean in terms of the cash benefit that you guys will see from bonus depreciation, did you get a lot of that in Q1 or should there be kind of a similar level of – just looking at the line, the deferred taxes line, in terms of the benefit for the rest of the quarters? Joseph Welch Yes. So technically, we have not received the cash benefit. So you probably noticed the income tax receivable in current assets of about $140 million, technically we’d be receiving that when we file our tax return for the 2015 tax year around mid-year. I think that’s the earliest time we can get that done. So we’re expecting that true cash inflow around mid-year, it is approximately $140 million for 2016. Caroline Bone All right, thanks so much. Joseph Welch Thank you. Operator [Operator Instructions] Our next question comes from Praful Mehta from Citigroup. Your line is now open. Praful Mehta Thank you. Hi guys, just quickly on that bonus depreciation again and I truly appreciate the point on the cash that you have now freed up. I guess if you do have this cash freed up in the long-term, as long as you can reinvest that cash at an accretive way in terms accretive asset or bid it out of CapEx, would that support – is that your thesis on why the growth rates remain the same? And secondly, does that change, now that you’re part of Fortis, if they could use that excess cash to grow some other part of the, I guess the combined platform, does that kind of change your perspective on how you think about bonus depreciation longer term, I guess? Joseph Welch It doesn’t change our perspective on how we view that at all. Rejji Hayes Yes, I think, Praful, the only thing I would add to that is from a capital deployment perspective, we’ll see what the options are at the time we receive the cash and clearly, assuming we get the transaction of the finish line post-closing, it will be discussion we have with the owners of the business, both Fortis and GIC as to what the most efficient use of that cash is, but needless to say it’s not going to be sitting in a money market account, earning 5 basis points. Praful Mehta And then just in terms of FERC 1000 and growth and development CapEx and the projects there, can you just briefly give us an update on how that is going and do you see any updates in terms of the growth projects more longer-term? Joseph Welch With regards to Order 1000? I think you could regard Order 1000 as a complete failure for the whole marketplace. In our case and you must not have been listening when we had some of our earnings calls in the past because I’ve directly highlighted that we’re not very focused on Order 1000 for the facts that I’ve just outlined. We have of Lake Erie Connector that we’re really focused on, we’ve announced that we’re doing work in Puerto Rico and Mexico. We continue to stay involved in Order 1000, but I think it’s a tree that doesn’t bear much fruit for anyone. Rejji Hayes And then Praful, this is Rejji, so the non-traditional development side, as we highlighted in our initial comments, we continue to make progress in the new Covert line which we should have in service this year and clearly the other opportunities, Lake Erie and some of the other non-traditional development opportunities as they continue to progress and we should have visibility on Lake Erie project in the latter half of this year. So continuing to push forward on that as well. Praful Mehta And I do pay attention, I do listen guys, it’s always just good to get a refresh, although I appreciate it. Joseph Welch You just wanted it refreshed? Praful Mehta Yes, always good to get your perspective again on FERC 1000, I guess. Joseph Welch Okay. Praful Mehta Thank you. Operator I’m showing no further questions. I will now like to turn the call back to Stephanie Amaimo for any further remarks. Stephanie Amaimo This concludes our call. Anyone wishing to hear the conference call, replay available through May 3, can access it by dialing 855-859-2056 toll free or 404-537-3406, passcode 83086632. This webcast to this event will also be archived on ITC website at itc-holdings.com. Thank you, everyone and have a great day. Operator Ladies and gentlemen, thank you for participating in today’s conference. You may all disconnect. Everyone, have a great day. Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) 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Energy Sector Crushes Conventional Wisdom

By Ronald Delegge Never mind the abysmal results of first-quarter earnings for the depressed energy sector. It doesn’t matter. And never mind the conventional wisdom of group-think and scary analyst warnings like, “Energy stocks are in deep trouble because Q1 losses will mark the first time any sector in the S&P 500 has reported an aggregate loss since Q4 2008.” Again, who cares? Price is what counts – not rigid EPS statistics – and right now energy stocks (NYSEARCA: XLE ) have ripped higher, making them the best performing S&P 500 (NYSEARCA: IVV ) industry sector year to date (YTD). ETFs like the Direxion Daily Energy Bull 3x Shares ETF (NYSEARCA: ERX ) that magnify the performance of energy stocks with triple daily leverage have delivered strong results by gaining almost 30% YTD. In other words, group-think would’ve caused you to miss this trade. And that’s why following conventional wisdom is a time honored recipe for failure. Click to enlarge Contrary to the nearly universal view that energy stocks are untouchable, on March 7 via ETFguide PREMIUM, we saw a great opportunity in oil and gas producers (NYSEARCA: XOP ) and issued the following alert: “XOP is right up our contrarian alley. It’s lost money over the past 1, 3, and 5 years with annualized losses of -9.45%. Who wants to puke? Despite proclamations that everyone will be driving Teslas by 2020, we don’t believe or agree that oil and gas demand will evaporate to zero as certain Kool-Aid drinking clean energy analysts envision. We’re buying XOP at current prices ($29.70).” XOP owns a basket of oil and gas companies like Continental Resources (NYSE: CLR ), Devon Energy (NYSE: DVN ), and WPX Energy (NYSE: WPX ). We added: “Although contrarian trades like XOP usually take longer to develop, they can be far more profitable compared to other types of trades. However, the problem of realizing profits is largely psychological. Why? Because most investors grow impatient and end up selling a great investment before it has time to blossom.” XOP has risen over +19% since our time stamped alert compared to just a +3.39% gain for the S&P 500 (See chart above). Oil and gas producers have also outperformed the broader energy sector. Much of this bounce is attributable to recovering crude oil prices (NYSEARCA: USO ), which now trade in the $45 per barrel range. Nevertheless, buying out-of-favor sectors before they start turning up is a perennial battle for most investors. Too few people do it. Why? Because they’re too scared a bottom hasn’t been reached. Bottom line: Contrarian trades – although often grueling – have a proven track record of success for patient traders and investors. It’s also why I salute all contrarians on this final day of Financial Literacy month! P.S. Contrarian trades are just one of four primary trading strategies we use at ETFguide for non-core investment portfolios. Original Post

The Ultimate Guide To Risk Parity And Rising Interest Rates

Click to enlarge Risk Parity has had a phenomenal year-to-date. One popular provider of the strategy for retail clients is up nearly 9% while the S&P is up a little over 3%. This is primarily due to big rallies in both the bond and commodity markets, as the Fed has continued to ease off on interest rates while the global outlook has stabilized. YTD Performance of Major Asset Classes vs. Risk Parity (labeled “You”) Source: Yahoo Finance, Federal Reserve , WSJ , Hedgewise Despite this strong outperformance, the bond rally has raised a familiar worry: what happens when interest rates rise? Given the strategy has a heavier bond allocation than most traditional portfolios, does it continue to be a viable option? Fortunately, we have decades of historical data that show that rising interest rates are not a cause for great concern. In times of high inflationary pressure, like the 1970s, the strategy is protected by assets like commodities and inflation-protected bonds. While higher short-term rates do reduce the benefits of using leverage, our backtested model still performed at least as well as the S&P 500 throughout the 70s. The absolute “worst case” scenario is one in which rates are being driven up by continuously strong real growth, such as the post-WWII economy from 1950 to 1970. In this situation, both bonds and real assets like gold will tend to perform poorly while the stock market rockets ahead. Though Risk Parity will probably underperform the S&P 500 over such a stretch, you will still make solid returns ; they simply won’t be as high compared to a portfolio of 100% equities. In exchange for this possibility, you avoid the risk that the next 2008 may be right around the corner. While rising interest rates may seem like a foregone conclusion, recent history in Germany and Japan demonstrates that rates may be just as likely to fall. In short, it only makes sense to move away from Risk Parity if you are absolutely sure we will experience a booming, robust economy over the next 20 years and you can afford a few 40% downturns along the way. If you have this conviction, by all means, move to 100% equities. If you aren’t sure, though, recall that Risk Parity is a long term investment strategy that has consistently produced reasonable returns without the need to predict the future. Modeling Performance in the 1970s: Inflation Protection Works From 1970 to 1983, the Federal Funds rate rose from 4% to nearly 20%, or a whopping 1600 basis points. The US was facing a vicious combination of rising prices and falling economic activity, also known as “stagflation”. This provided an excellent environment to pressure test the Risk Parity framework, which you might expect to do terribly given its heavy bond allocation. However, just the opposite occurred: our model outperformed equities nearly the entire time . To create the historical model, we had to make a few key assumptions: We are using a modified form of our proprietary risk management framework, as there was not nearly the amount of market data available in the 70s as there is today. Our belief is that this is a handicap, and we expect our framework would perform even better than is shown here if we had the same data available. We limited the portfolio to nominal bonds (NYSEARCA: IEF ), equities (NYSEARCA: SPY ), and gold (NYSEARCA: GLD ) because inflation-protected bonds (NYSEARCA: TIP ) did not yet exist, nor did reliable data on the price of commodities like oil and copper. The assets that we had to exclude all tend to perform well in periods of high inflation, and would likely buoy performance within our full model. Risk Parity is typically available at multiple ‘risk levels’, the higher of which amplify expected returns through leverage. We ran an unleveraged “Low Risk” version of the model as well as a leveraged “High Risk” version. The portfolios are based on end-of-day index prices and do not account for live trading conditions. All dividends and coupon payments are included and assumed reinvested. Leverage is assumed to have a cost equal to the rate on one-year treasury bonds. The model does not include the cost of commissions or management fees. Performance of Risk Parity “Low Risk” and “High Risk” Models vs. S&P 500, 1970 to 1982 Click to enlarge Source: Hedgewise Analysis Despite one of the worst decades for bonds ever in history, both versions of the Risk Parity portfolio outperformed equities for nearly this entire stretch. This was possible for two reasons. First, ten-year bonds still achieved an annualized return of about 6% during this timeframe. Even though rising rates eroded the principal value of the bonds, this was counterbalanced by consistently higher yields. Second, assets that provide protection from inflation, like gold, performed incredibly well in this environment as the value of the US dollar plummeted. That said, it is interesting to note that based on total return over the entire timeframe, the “High Risk” portfolio failed to outperform the “Low Risk” portfolio even though it was far more volatile and leveraged. This makes sense when you realize that short-term interest rates were often higher than long-term rates during this period. In other words, you were often paying more in interest than you were making back. Does this mean that using leverage doesn’t make sense when interest rates are rising? Not necessarily. The “High Risk” portfolio actually was outperforming most of the time; the net result was highly influenced by the final period in which rates rose most rapidly. Still, it is accurate to say that leverage will be less useful compared to periods of flat or falling interest rates. Taken together, these facts lead to a few important takeaways. Even if you are relatively certain that inflation is about to pick up, Risk Parity would still be a great choice . In this kind of environment, higher risk level portfolios may occasionally fail to outperform the lower risk levels, though they would all generally perform well compared to the S&P 500. If you are absolutely convinced that we are heading for another period like the 70s, you might consider avoiding leverage, but it certainly wouldn’t make sense to abandon the strategy altogether. Before we move on, keep in mind that the decade of the 70s was the earliest period of rising rates in which we had enough data to do a proper simulation of our model. When studying the 50s and 60s, we must rely on a drastically more simplistic version. Still, this severely handicapped portfolio can effectively demonstrate some of the timeless concepts of the Risk Parity Framework. Modeling Performance in the 1950s and 1960s: The Boomer Years The Post-WWII economy in the US was incredibly robust. For nearly 20 years, we experienced strong real growth with relatively limited inflation and no major recessions. The S&P 500 grew by over 10% annually, while nominal bonds returned only 2% annually due to consistently rising real rates. You’d expect a portfolio of 60% bonds would make no sense; never mind adding leverage to the mix! However, such a portfolio still provided solid, steady returns with a lower risk of drawdowns . Using leverage also successfully increased returns, though not significantly. This was true even with no active risk management and during two of the worst performing decades for nominal bonds in history! To be clear, in hindsight, equities were the top performing asset class, and any mix besides 100% stocks probably underperformed. However, this fact misses the entire point of diversification: you just don’t know what is going to perform well next. Of course you will do better if you always switch into the asset class that is about to blow the others away, but you’ll often be wrong. Risk Parity allows you to consistently do well regardless of the environment. With that said, let’s take a look at the data from these decades. Here’s how we constructed the model this time: Since data was not available to implement active risk management, we assumed a static split of 40% stocks and 60% bonds for the Risk Parity portfolio. We took this same mix and added 75% leverage, for a final mix of 70% stocks and 105% bonds. This is a simple, static performance model that is limited to two assets. Performance of our full model in the same time period would likely have been better. Performance of 40% Stock / 60% Bond Mix and Leveraged 40/60 Mix vs. S&P 500, 1953 to 1970 Click to enlarge Source: Hedgewise Analysis As expected, the bond-heavy mix was unable to keep up with equities over this timeframe. However, both the unleveraged and the leveraged versions of the portfolio still performed reasonably well from an absolute standpoint. The unleveraged 40/60 mix averaged an annual return of 5.5% with less than half the volatility of the stock market and significantly smaller drawdowns. If your goal was capital preservation and moderate growth, this portfolio may have still been a better choice. While it’s easy to argue otherwise when you look over the 20 years, stocks experienced a number of significant declines during that timeframe that may have been unacceptable for someone close to retirement or with a shorter time horizon. For example, stocks lost as much as 31% during the dips in 1958, 1962, 1966, and 1968. If you needed to exit the market during these periods, or you were actively taking withdrawals out of your investments along the way, such losses could significantly damage your outlook. With our leveraged mix, we see a similar theme to what occurred during the 70s: you will still achieve higher returns using leverage, but not significantly so. Importantly, this dispels the myth that levering up a Risk Parity portfolio will be disastrous when bonds do poorly. The leverage is not harmful; it just isn’t as helpful compared to other times. Plus, remember that the modern day version of the portfolio would likely exhibit a much smaller performance gap compared to the one shown here. The key to this analysis is deciding what it means to you. First, consider how sure you are that stocks will be the top performing asset class over the next 20 years due to strong real growth and low inflation. If we experience any other kind of environment, Risk Parity will tend to outperform. Second, evaluate how damaging each worst-case scenario might be for you personally. If you moved to 100% equities at the peak of the dot-com bubble, it took you nearly a decade to recover your losses. If you utilized a simplistic version of Risk Parity during the Post-WWII era, you still made 6.6% instead of 10.4%. As with any kind of diversification, it only makes sense if you agree that the future is quite uncertain. As much as it may seem that bonds are about to enter a prolonged bear market, there’s a good deal of evidence that suggests quite the opposite. Where Have the Rising Interest Rates Gone? Supposedly, the bond bull market in the US has been on the verge of ending for about 4 years now. There was the so-called ‘taper tantrum’ in 2013, during which yields rocketed over 100bps when Bernanke announced the end of ‘Quantitative Easing’. Yet the US economy continued to sputter along slowly and global weakness brought yields back down. In late 2015, the Fed was expected to raise rates as many as 6 times in the near-future. Then, a global collapse in commodity prices and rapidly slowing growth in China caused them to back-off again. Meanwhile, ten-year bonds have continued to hover around 2%. 10-Year US Treasury Yields Since 2000 Click to enlarge The gut reaction to this graph is to think that we must be near the bottom. However, there is no reason that we can’t fall well below a 2% yield for decades. Japan, for example, has had ten-year yields under this level for almost 20 years. 10-Year Japanese Treasury Yields Since 1990 (2% yield emphasized) Click to enlarge Many are quick to point out that our economic history is quite a bit different than Japan’s. Instead, let’s take a look at Germany: 10-Year German Treasury Yields Since 2000 (2% yield emphasized) Click to enlarge The reality is that the entire world remains in a very fragile state. On a relative basis, yields in the US are actually still pretty high. In the EU, a number of countries have recently introduced negative interest rates to continue to combat recessionary pressure. The point is that we may be at the end of the bond bull market, but it’s also entirely possible that we are not. Conclusion: Rising Rates Are Not a Big Concern The evidence presented in this article helps clarify some extremely important concerns about Risk Parity. In the thirty-year stretch from the 1950s to the 1980s, adding leverage to a bond-heavy portfolio never resulted in disaster; it just had less of a positive effect on returns. During the most inflationary period in US history, our model outperformed the S&P 500 for a majority of the time. These facts boldly refute the idea that Risk Parity only ‘works’ during bond bull markets. As with any kind of diversification, there will always be periods when one asset is outperforming the others. In exchange for tolerating this, you get steadier, more reliable returns which do not depend on you predicting the future. You become less vulnerable to a crash in any given market. You’ll tend to make money even when interest rates are steadily rising, but you’ll make less than you could have if you had perfect foresight. Even if you do have a strong conviction that rates are about to rise, an unleveraged Risk Parity portfolio remains an excellent choice for investors with a shorter timeframe because of its significantly smaller drawdowns and steady historical returns. We would absolutely recommend such a portfolio over cash regardless of the market environment. For longer term investors, be wary about the likelihood that we are about to enter a period of growth similar to the post-WWII economy. As many countries in Europe and Asia have already demonstrated, another recession may be a far bigger risk. Finally, please keep in mind that this article focused on extreme scenarios, including the naïve construction of the model portfolios and the chosen start and end dates of the analysis. If the Risk Parity framework can hold up relatively well despite these handicaps, there’s little reason to keep worrying about the specter of rising interest rates. If you are interested in learning more about Risk Parity, check out this white paper overview . We’ll also be publishing the current construction of our “Low Risk” and “High Risk” portfolios early in May. Be sure to follow us if you’d like to receive it. Disclosure: I am/we are long SPY, IEF, TIPS, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. To the extent that any of the content published may be deemed to be investment advice or recommendations in connection with a particular security, such information is impersonal and not tailored to the investment needs of any specific person. Hedgewise may recommend some of the investments mentioned in this article for use in its clients’ portfolios. Past performance is no indicator or guarantee of future results. This document is for informational purposes only. Investing involves risk, including the risk of loss. Information in this document has been compiled from data considered to be reliable, however, the information is unaudited and is not independently verified. Performance data is based on publicly available index or asset price information and does not represent a live portfolio except where otherwise explicitly noted. All dividend or coupon payments are included and assumed to be reinvested monthly.