By David F. LaffertySVP – Senior Investment Strategist,Natixis Global Asset Management
People often say that "timing the market" is a fool's errand. This applies not only to the stock market, but also to bonds, as interest rates are notoriously difficult to predict. That said, interest rates are abnormally low now and investors should begin planning for higher yields - even if we don't know when interest rates will rise.
As always, there is no free lunch in the capital markets, but here are five basic strategies for addressing the risk of higher interest rates and fixed-income losses:
1) Shorten bond duration/maturity
Duration is a measure of a bond's sensitivity to changes in interest rates. Bonds or bond portfolios with a shorter duration realize their cash flows sooner. This results in less price risk as interest rates rise, and smaller gains should rates fall. Problem solved, right? Not really. The shape of the yield curve often makes this an expensive solution. When most investors believe rates are going up, like today, they purchase shorter-duration bonds (driving down the bonds' yields) and sell longer duration bonds (driving up their yields). As a result, the yield curve may be relatively steep, with shorter maturities yielding significantly less than longer maturities, as is the case today. Therefore investors pay an implicit price for shortening duration, in the form of lower yield and less income. This option may not be attractive for many income-dependent investors.
2) Focus on bonds or bond market sectors that don't move in lockstep with Treasury interest rates
When we think of rising interest rates, we usually think in terms of high quality, sovereign, base interest rate issues like U.S. Treasury securities or German Bunds. However, not all bonds move in lockstep with these base treasury rates. The general rule is that lower-quality bonds and non-U.S. dollar issues are inherently less interest rate sensitive than higher quality bonds issued in U.S. dollars. Rising interest rates are generally associated with positive economic developments, improving credit profiles and "risk-on" assets. So fixed-income sectors that typically hold up well when rates rise include the lower end of investment-grade credit (Single-A and BBB-rated bonds), high yield bonds, emerging market debt, non-dollar bonds, and convertible bonds. The key is to remember is that not all bonds are created equal when it comes to rising interest rates. However, this strategy is also not without risk. These sectors that are generally less-sensitive to rising rates are almost certainly more speculative and volatile. An investor going down this path may be avoiding interest rate risk, but is taking on additional credit risk.
3) Own bonds or sectors whose coupon and cash flow dynamics change with interest rates
Rising interest rates present a problem for fixed-income securities, but not all bond types offer "fixed" interest payments. Some bonds offer income payments that adjust with market interest rates or yields. While there are many exotic issues that might qualify here, the two choices that most readily come to mind are TIPs (Treasury Inflation Protected Securities) and bank loans. For TIPS, coupon and maturity payments are indexed to higher inflation, which is a primary component of higher yields. In the bank loan market, loans (made by banks to corporations) are tied to variable, short-term interest rates, such as LIBOR, so their yields can "float" up as rates rise. As a result, both TIPS and bank loans have the ability to keep up with higher interest rates which makes them wonderful asset allocation tools. However, as always, there is a catch. In the case of TIPS, these issues represent investors' expectations of "real" interest rates. If interest rates are rising due to economic growth (real rates) and not inflationary pressure (as measured by the Consumer Price Index), their coupon and principal will not adjust and they offer little protection against higher yields.
Moreover, in today's environment, where inflation is higher than nominal yields, TIPS offer negative real yields - not very appetizing to most clients. In the case of bank loans, these issues are generally made to below-investment-grade borrowers, so like high yield bonds, they incur greater credit risk. In addition, bank loan coupons float with short-term interest rates, so their protection is more modest if only longer-term yields are rising (i.e., a steepening yield curve).
4) Add yield to your bond portfolio
In a bond portfolio, the income a bond pays offers some cushion against the principal losses resulting from higher interest rates. Simply put, a bond with more income can incur larger principal losses before its total return (income +/- change in price) goes negative. So is this the solution - just buy higher yielding bonds? Not really. This strategy is highly akin to # 2 above. Increasing yield almost always means increasing credit risk and volatility. No free lunch again.
5) Find income outside the bond market
One way to avoid bond market risk (i.e., higher rates) is simply to reduce your exposure to bonds. There are many sources of investment income that fall outside of the bond market. These include dividend-paying stocks, preferred stocks, real estate investment trusts (REITs), and master limited partnerships (NYSEARCA:MLPS) to name just a few. Most of these investments are tied far more to their own underlying corporate fundamentals than to changes in market yields. As a result, they too can be effective tools in reducing interest rate risk. However, equity and equity-related investments, by definition, sit lower in the capital structure, so these asset classes also incur significant credit and price volatility - see #2 and #4 above. Moreover, this move from "bond income" to "equity income" inherently and significantly alters a portfolio's core asset allocation make-up - a change that should not be undertaken lightly.
Investors looking to mitigate rising rate risk have a myriad of portfolio strategies they can use, but each comes with its own risk/return trade-offs. Investors seeking to build a durable income portfolio should consider a diversified approach to this problem, incorporating a little bit of all five strategies above. Bonds have a place in every portfolio, but the investments that have worked so well in the falling rate environment of the past 30 years may no longer be up to the task when interest rates start rising again.