The recent rise in interest rates has many bond investors on edge, particularly regarding its impact on the fixed income allocation within a diversified portfolio. In some cases, investors are making wholesale shifts, swapping the interest rate risk of a fixed-rate payment for credit risk (of, for example, a floating-rate payment). But is that the best approach to mitigate interest rate risk? Below, I’ll address how average investors can position their portfolios for a rise in rates through strategies that use common exposures—and don’t require a complete portfolio repositioning.
Looking Beyond Duration
When investors express concern over the price impact that rising interest rates have on their portfolios, they’re typically referring to interest rate risk—the potential for bond prices to drop when interest rates rise. This risk is often measured by looking at a fixed income instrument’s duration (i.e., a calculation of its sensitivity to interest rate changes). For instance, if an instrument’s duration is five years, then a parallel move up in rates of 100 bps (i.e., a 1 percent rise in rates) should translate into a 5 percent loss for the portfolio, all other relevant factors being equal.
While applicable in theory, this so-called hard duration measure is too simplistic when assessing interest rate risk for a portfolio. It doesn’t do a very good job of addressing exposures in a holistic context. Hard duration is a better metric for assessing the price impact of interest rates on a single security, such as a U.S. Treasury bond, than on an entire portfolio or mutual fund with multiple exposures. Why? Most portfolios include an array of exposures (diversification!), which, when combined, can do a fairly good job of mitigating interest rate risk, just as traditional diversification does.
Let’s take a closer look.
Historically, long-term Treasury securities have come with the strongest interest rate risk. But spread-oriented products—corporate bonds, mortgages, high-yield investments, and bank loans—often have many other characteristics that influence how the particular security trades.
For example, investors should be aware that:
A movement in Treasury rates one way or the other doesn’t always translate into a corresponding movement in price based on a stated duration.
Corporate bonds, especially lower-quality issues in the high-yield space, have historically exhibited a positive correlation with an increase in rates, recording a stronger link to equities than to Treasury securities over time.
When the economy improves and interest rates move higher, many lower-quality securities get upgraded (moving, for example, from a BBB- to an AA- rating), which results in an increase in their price.
Consider a mutual fund that holds AAA and BB bonds in an improving economy associated with rate increases. In this situation, there would certainly be downward pricing pressure on the portfolio’s AAA securities due to interest rate sensitivity and their Treasury-like credit quality. At the same time, some issues in the lower-quality BB space would most likely be upgraded as general economic fundamentals improve. Overall, the fund’s volatility would likely be mitigated, with some securities (e.g., higher-quality bonds) seeing downward price pressure and others (e.g., lower-quality bonds) experiencing upward movements in price.
Strategic approach. Invest in fixed income mutual funds that hold a diversified combination of spread-oriented sectors in an effort to reduce the interest rate sensitivity of their portfolios.
Another way investors can reduce the interest rate sensitivity of a portfolio is through the use of foreign fixed income securities. It seems unlikely that interest rates around the world would all rise at the same time, affecting securities in the same fashion. Even though markets are becoming more integrated, a fair amount of segmentation still exists. Accordingly, correlations among rates in various developed and emerging countries remain somewhat muted.
For instance, what if Brazilian yields were to rise as a result of inflationary pressures at a time when Singapore was entering a recession? A portfolio could experience a decline on the Brazilian position and a corresponding increase from the exposure to Singapore sovereign debt, effectively netting out any price impact from a move in rates.
Strategic approach. Incorporate global fixed income in a portfolio to help reduce the interest rate sensitivity to domestic rates.
Generally, when markets see an increase in rates, it’s in response to inflationary fears and an expanding economy. This is the environment we’re witnessing today. Coincidentally, when an economy is expanding at a healthy pace, corporate earnings growth typically accelerates and equity prices move higher. Investors become more optimistic about the future of the economy. Consequently, in a rising rate environment, equities can represent an attractive asset class and act as a ballast to a portfolio’s fixed income allocation.
Strategic approach. Include equity exposures in a portfolio, even in small increments. It’s a time-tested way to help reduce interest rate sensitivity and preserve the real value of portfolios over time.
Key Rate Duration
Last but not least, consider the notion of key rate duration. Above, I outlined the potential impact on a portfolio of a parallel curve shift—a situation when interest rates for all maturities increase or decrease by the same amount. The truth is, parallel shifts occur rarely, if ever. Therefore, to truly understand how a portfolio or bond fund will react to rate movements, you need to assess the fund’s key rate duration.
This type of measurement assesses how portfolios are affected by nonparallel shifts in the rate curve, which are more frequent than parallel shifts. For instance, for a portfolio invested 50 percent in cash and 50 percent in the 10-year Treasury, the total duration will be somewhere in the 5-year range. (Cash has zero duration, and the 10-year Treasury is around 10 years in duration.) Investors might look at that number, assume their duration is 5 years, and then calculate the price decline based on a 1 percent move higher in rates. In reality, if rates on the 1-year to 7-year portion of the curve move higher and the 10-year yield stays the same, a portfolio will not be affected. That’s because the portfolio is not exposed to the portion of the Treasury market that experienced an increase in rates.
Strategic approach. Hold securities with varying maturities to help reduce the interest rate sensitivity to certain segments of the market.
It’s About Total Return
Surprisingly, an often-overlooked aspect of fixed income investing is that bonds are interest-bearing instruments that will continue to pay income until maturity. Their total return includes both price movements and income received. Simply put, total return = price return + income.
Therefore, an aspect to consider is the reinvestment of principal and interest. As rates move higher and bonds mature, these funds can be reinvested at higher and higher yields—which further increases the income derived. Many mutual fund managers hold bonds with very short maturities. The bonds constantly mature and are reinvested at more attractive yields as rates go up. Consequently, in a rising rate environment, the dividend payment from a fixed income mutual fund will typically move higher as well.
Insurance That Pays You
If positioned correctly, fixed income is an asset class that can perform well when other securities are being sold off, as occurred in the March 2020 downturn. The added benefit, of course, is that investors receive interest payments, in addition to holding the instrument’s principal value. As I like to think of it, it’s almost like holding insurance that pays you.
A properly styled fixed income allocation that incorporates the strategies described above could help position a portfolio to withstand a rise in interest rates. Making a knee-jerk reaction to a rise in interest rates by concentrating a portfolio in one or two areas that lack interest rate sensitivity could set an investor up for failure. Perhaps the best way to react to rising interest rates is to simply enjoy the additional yield.