It’s as true in investment planning as it is in physics: What goes up must come down. For fixed-income investors, though, the more pressing fact is that what has gone down must come up.
Interest rates have reached record lows in recent years, and the largest share of the credit goes to the Federal Reserve. Under U.S. monetary policy, the Fed controls the federal funds rate, an important benchmark in financial markets, and by extension, exerts heavy influence on short-term lending rates. Since the 2008 financial crisis, these rates have been kept extremely low; as economic improvement continues, however, they are expected to rise. No one knows when or how fast, but it is safe to say that interest rates have nowhere to go but up.
This is a concern for fixed-income investors because bond prices have an inverse relationship with interest rates. The prospect of rising rates represents risk. All bonds have maturity dates, when the lender-investor is due to receive the bond’s principal amount. The duration of a bond is a calculated figure that represents the average time in years a bond will take to repay the initial investment. How much risk rising interest rates pose to a particular bond’s value largely depends on a bond’s duration; the longer it takes an investor to recoup his or her investment, the more likely the bond is to lose value because of rising rates. As an estimate, the percentage change in value can be expressed as the bond’s duration multiplied by the change in interest rates.
Yet fixed-income investors are not powerless just because a rise in interest rates is inevitable. Nor should investors abandon fixed-income assets; since these assets have a low or even negative correlation to equities, eliminating them from a portfolio increases other risks.
As with any investment plan, there is no one-size-fits-all strategy. The techniques described here are not the only options, and any plan should be tailored to an individual portfolio based on the investor’s risk tolerance, liquidity needs, investment horizon and personal goals. It is also worth noting that the best way to assess various strategies is total return: This includes both the bond’s stated yield and any capital gain or loss arising from the sale of a bond (or bond fund). Further, rising interest rates are not the only risks of fixed-income investments. Credit quality, or the risk of default, stands as the other major risk factor for bond investors, who should evaluate the probability that the borrower will fail to make payments as promised.
Reduce interest rate risk. Perhaps the most straightforward strategy for dealing with the potential for rising interest rates is to reduce the overall duration of a fixed-income portfolio. This is a rather conservative approach, since short-term fixed-income investments generally offer lower yields in exchange for minimizing interest rate risk. Low-duration options include mutual funds, individual bonds, certificates of deposit (CDs), money market funds and government securities.
An investor can match the maturity of many of these investments with short-term liquidity needs, since they offer a full return of principal as long as the issuer does not default. However, most of these options bring their own risk: minimal or even negative “real” returns when taking inflation into account. When held individually, these options also generally offer less diversification, another risk for the holder.
The exception is bond mutual funds. Bond funds will typically include a benchmark average duration to which the manager adheres. This provides for added control over the fund’s role in the investor’s fixed-income portfolio without the need for constant maintenance. An investor mostly concerned with interest rate risk should steer clear of fixed-income funds with long-term duration targets, whether actively or passively managed. An actively managed fixed-income fund not constrained to a specific duration can invest across different products with a variety of maturities, and is likely to adjust its investments according to fluctuations in interest rate expectations. As with any actively managed fund, an investor gives up some control, so it is important to research and trust the manager’s strategy.
With either a passive or an actively managed bond fund, an investor can secure much greater diversification than is possible with individual holdings. Further, costs are often lower as a result of the efficiencies created through bulk purchases unavailable to most individual investors.
Optimize fixed-income yield. For investors who believe that reducing interest rate risk alone is too conservative, maintaining yield will involve looking to other products, increasing credit risk or both. An investor should carefully consider both yield and duration for fixed-income investments in the context of balancing investment goals with risk tolerance.
Many investors may find a role for floating rate or bank loan funds. These funds purchase loans made by banks to companies with below-investment-grade credit ratings, which are typically priced at a certain spread above the London Interbank Offered Rate, or Libor. The underlying loans’ yields generally rise along with broader market rates, protecting investors from most interest rate risk. And, unlike high-yield bonds, floating rate loans have safeguards built in, including collateral, performance-based covenants and a senior position within a company’s capital structure. Many have provisions that do not adjust the coupon, or periodic interest payment, lower than a set floor should interest rates fall. These funds are beneficial when interest rate risk is a greater concern than the credit risk of the underlying investments.
Other options can be useful, depending on an individual’s tax situation. For example, tax-free bond funds can provide more attractive after-tax returns than taxable fixed-income funds for investors in certain tax brackets, depending on the yields they offer. Since they involve municipal securities, such bond funds also add diversification. However, municipal securities are not immune to default, so it is important to evaluate the municipality’s current financial position and future prospects.
Some investors may also wish to consider alternative products that act similarly to fixed-income investments. Various absolute return or hybrid strategies that may not actually hold fixed-income securities can produce similar risk and return characteristics. One example is merger arbitrage, which entails a hedge fund strategy achieved by, in its simplest form, purchasing shares of a merger acquisition target at a slight discount to the expected value upon completion of the deal. This price difference is known as the arbitrage “spread” and is captured as long as the deal is completed. If it falls through, other protection hedges leave investors virtually where they started before the investment was made. Merger arbitrage strategies are often offered through fund companies, leaving many of their intricacies to experienced managers rather than to individual investors.
The damaging effects of inflation on a fixed-income investor’s purchasing power should also be of concern. Many investors make the mistake of believing that Treasury Inflation-Protected Securities (TIPS) provide a risk-free source of true inflation protection. But “risk-free” is hard to come by, and TIPS are no exception. Long-term TIPS carry significant interest rate risk similar to that of other long-term securities. Further, if actual inflation significantly deviates from expectations, TIPS’ value can slide. Hybrid strategies that incorporate inflation swaps alongside short-term fixed-income holdings are an effective way to mitigate the effects of inflation while keeping interest rate risk low. An inflation swap generally involves one party paying a fixed rate on the swap amount in exchange for a floating-rate payment based on actual inflation.
When attempting to optimize yield, high-yield bond funds initially may seem attractive. High-yield bonds are issued by below-investment-grade corporations, and so must pay a higher coupon to attract investors. These “junk bonds” can pair a short duration with the high coupon, leading to less sensitivity to interest rate changes, too. However, the risk of default may be high enough to largely offset the cushion provided against interest rate changes by the higher yield.
Reduce reinvestment risk. An often-suggested method for mitigating the risk of rising interest rates is the “laddered” bond portfolio, consisting of individual bonds with staggered maturities. As shorter-term bonds mature, the investor reinvests the proceeds into the longest-term “rung” of the ladder, providing a higher yield as long as interest rates are increasing. The staggered maturity payouts also create flexibility, so the investment can be redirected to more advantageous strategies if interest rates suddenly fall. This concept is known as reinvestment risk, or the risk of future coupons and maturity payouts being reinvested at rates lower than the initial bond purchase.
The risk with a laddered bond portfolio, as with any fixed-income portfolio based on individual bonds, is the lack of diversification. In addition, this strategy involves increased transaction and maintenance costs, especially if an investor attempts to properly diversify his or her holdings. To address this problem, some investors turn to ladder-diversified fixed-maturity exchange traded funds (ETFs), which hold investments maturing close to the same date. While such ETFs are designed for the investor to hold until the bonds mature, their structure allows for easier trading if liquidity needs arise or the investor changes his or her strategy. This flexibility creates the risk that a fund manager will be forced to sell the underlying securities under suboptimal conditions and generally presents itself through wide bid-ask spreads.
No one can know precisely when or how fast interest rates will rise. In theory, laddering is a way investors can avoid attempts to time the interest rate environment. In this, laddering is analogous to dollar-cost averaging. However, like dollar-cost averaging, it ignores some of the realities of the market and may cost an investor money in the long term.
At Palisades Hudson, we have been wary of the dangers of rising rates in the bond market for some time. We have used many of the strategies I have described to position our clients’ portfolios accordingly. We believe investors are best served by focusing on maximizing the total return of their portfolios over the long term, rather than trying to pursue maximum current income in today’s low-rate environment. Therefore, we continue to recommend that clients invest the majority of their fixed-income allocations in low-yield, low-risk investments that may include money market funds, short-term corporate and municipal bond funds, floating-rate loan funds and funds pursuing absolute or hybrid return strategies. Although these investments will earn less in the short term than a riskier bond portfolio, rising rates will not hurt their principal value as much, and more capital will be available to reinvest at higher interest rates.
Once bond yields begin to approach their historical averages, we will recommend that investors move certain assets into longer-duration fixed-income securities. However, even under normalized interest rate conditions, we typically advise clients to invest the majority of their fixed-income allocations in short- and intermediate-term bonds. Conservative investments are used for reducing volatility of the total portfolio and preserving wealth, not risking it.
Fixed-income investments will remain a useful component of most portfolios, even as interest rates inevitably pull up from their record lows. As conditions change, investors will simply need to remain aware of the environment and respond with long-term planning tailored to their individual needs and goals.
