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To set the stage for this article, we will first look at three periods of rising interest rates within the last 20 years. Using these past periods will allow us to analyze the predictability of moves in the treasury yield curve during a rising interest rate environment. Understanding the strain of projecting yield curve shifts allows us to comprehend the importance of fixed-income portfolio construction. To further expand the importance of fixed-income portfolio construction, we will review what has happened to the European fixed-income market over the past 10 years.

We will analyze how a conservative, passive investor's portfolio has shifted from a high-quality bond allocation toward a basket of low credit quality bonds over the past 10 years. Examining this portfolio will help us to demonstrate the importance of active management for fixed-income portfolios. Finally, we will explore the current fixed-income opportunities available due to the recent changes discovered in this article.

Three Periods of Rising Interest Rates

First, let's look at the time period from May 31, 2003, to June 30, 2006, in which the two-year U.S. treasury yield curve increased 383 basis points, the five-year U.S. Treasury yield curve increased 280 basis points, and the 10-year U.S. Treasury yield curve increased 178 basis points as seen below.

Click to enlarge images.

Figure 1: U.S Treasury Yield Curve Comparison -- May 31, 2003, to June 30, 2006

Source: U.S. Treasury, Bloomberg, Federal Reserve H. 15 Report.

In this three-year time period the U.S. treasury yield curve shifted from a normal shape to a flat shape as the Federal Reserve raised the fed funds rate by 425 basis points from 1.00% to 5.25%. Looking at a second time period from Sept. 30, 1998, to Jan. 31, 2000, we see a very much different shift in interest rates. In this 16-month time period, the two-year U.S. treasury yield curve increased by roughly 231 basis points, the five-year U.S. treasury yield curve increased 248 basis points, and the 10-year U.S. treasury yield increased by approximately 224 basis points at the same time.

Figure 2: U.S. Treasury Yield Curve Comparison -- Sept. 30, 1998, to Jan. 31, 2000

Source: U.S. Treasury, Bloomberg, Federal Reserve H. 15 Report.

The big difference during this time period compared to the time period analyzed earlier is that interest rates rose fairly evenly across the yield curves, and investors portfolios would have been affected similar across numerous fixed-income structures independently of their individual durations. Let's now look at a third time period, from Sept. 30, 1993, to Dec. 31, 1994, in which the two-year U.S. treasury yield curve increased by 380 basis points, the five-year U.S. treasury yield by 304 basis points, and finally the 10-year U.S. treasury yield curve by 244 basis points. It is notable that during this time period interest rate made a meaningful up move across the board as seen in Figure 3 below.

Figure 3: U.S. Treasury Yield Curve Comparison -- Sept. 30, 1993, to Dec. 31, 1994

Source: U.S. Treasury, Bloomberg, Federal Reserve H. 15 Report.

It is very important to isolate interest-rate risk from other factors that can negatively or positively influence a fixed-income investors portfolio. As seen during the three time periods analyzed in this article, rising interest rates do not always result in the same outcome and do not affect your fixed-income allocation equally. It is highly recommend to deconstruct your fixed-income portfolio to analyze which risk factors can be eliminated and which risk factors are most sensitive to interest rate shifts. We can summarize that short-term and long-term interest rates don't move the same way at all times.

Investors should be aware that the Federal Reserve Board controls the federal funds target rate. The federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other, usually overnight, on an uncollateralized basis. While closely monitoring the economy the board of the Federal Reserve has the power raise or lower the federal funds target rate in order to maintain a healthy economy, price stability or inflation. The federal funds target rate is a short term rate, while the U.S. treasury 10 year yield is a long term rate and mainly driven by general anticipations of changes in inflation and the health of our economy (Board of Governors of the Federal Reserve System)

Current Market Situation -- The "Bad"

Many investors will feel a surprising effect of an increase in short-term interest rates on their fixed-income portfolios. The shorter end of the yield curve does not always move according to the longer end of the yield curve. Many investors holding fixed-income securities will be affected very differently and fixed-income portfolio constructions becomes more and more important in times of low interest rates and quantitative easing (often called "tapering" by the general public). The main objectives of most fixed-income portfolios are to preserve capital, to generate income, to diversify, or to offer liquidity to an investor's portfolio.

But low interest rates are not the only challenge fixed-income investors face in the current market environment. Over the last 25 years many investors allocated their fixed-income assets toward the so-called safe strategies and mainly used government bonds. I don't only see this strategy used by retail investors, but also large institutional retirement plans. For many years aggregated bond index funds used to be the only diversifier in many portfolios. But in recent years the bond rally came to a halt and significant changes occurred in the fixed-income market, changes that dramatically impacted many investors without noticing.

Since 2007 until 2012, outstanding sovereign debt of advanced economies increased by roughly 12%, while AAA-rated government bonds decreased by roughly 50%, when during the same period AA-rated bonds increased by roughly 64%. The ML AAA Global Index decreased from roughly 5,331 to 3,586 over the same time period, followed by a significant increase in default probabilities for AAA-rated bonds in 2007 at 0.1% and AA-rated bonds in 2007 at 0.1%-1.3%, and 2.4% in 2011.

If, for example, an investor had chosen to invest in the Barclays EU Aggregate Index in 2002, he or she would have had invested in an index composite made up of 60% AAA-rated bonds, 29% AA-rated bonds, 8% A-rated bonds, and only 4% BBB-rated bonds. Knowing that triple-AAA rated bonds are considered to be prime and even a single A-rated bond is still considered to be upper/medium grade, a passive Barclays EU Aggregate Index investor would have had a fairly safe fixed-income allocation of mainly prime to upper quality bonds during this time period.

Figure 4: Barclays EU Aggregate Index -- A Partial View as of June 2002

Source: Barclays.

And 10 years later, in 2012, the same investor would have had a fixed-income allocation composed of 50% AAA-rated bonds, 10% AA-rated bonds, 25% A-rated bonds, and roughly 15% BBB-rated bonds without changing his or her allocation. This investor, who strictly maintained a stable allocation to the Barclays EU Aggregate Index seeking a fairly safe allocation toward highly rated fixed-income securities, would have seen his or her portfolio's credit quality decline over time.

Figure 5: Barclays EU Aggregate Index -- A Partial View as of 2012

Source: Barclays.

Many individual investors face exactly this dilemma in their portfolios -- often in the retirement accounts offered by their employers. While maintaining a stable fixed-income allocation in their portfolios, investors over time moved toward an allocation composed of lower quality and overvalued government bonds. The illustration above shows the risk of having a high correlation to any fixed-income index in the current market environment.

Current Market Situation -- The "Good"

But not everything is bad for fixed-income investors, since diversification benefits due to significant lower correlation between major asset classes decreased over time. While AAA-rated and AA-rated bonds were almost perfectly correlated, that figure approximately declined to 0.50 AAA-rated, 0.98 A-rated to now 0.45 AA-rated, 0.98 A-rated and now 0.55. An actively managed fixed-income portfolio is key to being well-positioned during the current market environment and scenario of rising interest rates. I highly recommend to avoid the following investments:

  • iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG)
  • Schwab U.S. Aggregate Bond ETF (NYSEARCA:SCHZ)
  • Vanguard Total Bond Market (NYSEARCA:BND)
  • SPDR Barclays Aggregate Bond (NYSEARCA:LAG)
  • Columbia Core Bond ETF (NYSEARCA:GMTB)
  • Guggenheim Enhanced Core Bond ETF (NYSEARCA:GIY)

These investments will give you a significantly higher exposure to overvalued government bond issues (a risk explained in one of my previous articles, "The Risk Of Passive Bond Investing").

Those who are invested in ones such as iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), Vanguard Long-Term Bond ETF (NYSEARCA:BLV), and iShares Core Long-Term U.S. Bond ETF (NYSEARCA:ILTB) might want to pay special attention to the longer end of the yield curve. People who are invested in ETFs such as Vanguard Short-Term Bond ETF (NYSEARCA:BSV) and iShares Core Short-Term U.S. Bond ETF (NYSEARCA:ISTB) can be affected by both ends of the yield curve. Also, those invested in ETFs such as Pimco Total Return ETF (NYSEARCA:BOND) need to find where they are.

It would be too much work to mention all ETFs that can be negatively or positively effected by an increase in interest rates. But oftentimes I have heard investors seeking to hedge their portfolio against increasing interest rates discussing ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT). There are many useful articles on Seeking Alpha discussing this, and I highly recommend studying the complexity of such an investment before allocating funds toward a leveraged ETF.

Recommendation

In the current market environment and scenario of rising interest rates, active will most likely beat passive. One needs to construct a portfolio of risks worth taking and identify unwanted risk factors, such as overallocations to higher duration fixed-income securities or strategies with a low return/risk profile and government bond issues. There are several investment strategies that can be followed to achieve this diversification goal or to hedge against unwanted risk factors. The variety of markets, maturities, currencies, and strategies available will allow you to apply these strategies efficiently.

Investors should seek fixed-income investments with low interest rate sensitivity. Since I believe taking on interest rate risk is not compensated in the current market environment, I recommend investing in fixed-income products with low to zero duration. This can either be achieved through fixed-income securities and the use of derivatives to hedge interest rate risk, or through structured flexible mutual funds (e.g., unconstrained bond funds). In a market where government bonds are certainly overpriced, I do not see any value added seeking higher credit quality in the government bond market, where investors are not compensated for the premium they will have to pay to participate in these investments. Yields offered in Germany, France, Italy, and Spain have significantly diverged, setting up the fundamentals for great opportunities for strategies exploiting spread differentials.

Rising interest rates should not only concern investors allocating their funds toward fixed-income instruments with the most significant sensitivity to interest rates. In the current market environment, characterized by historically low interest rates and decreasing correlations between major asset classes, many arenas of the global fixed-income and equity markets can be used to construct portfolios that meaningfully reduce the overall interest rate risk -- or even boost performance. However, it is very important to reference that predicting where interest rates will go -- and especially when -- is a pure guessing game. Looking at the above three time periods of increasing interest rates permits us to compare the treasury yield curve at the beginning and the end of these time periods to see how rates, in fact, changed.

Source: A Fixed-Income Dilemma

Additional disclosure: Primary and secondary data source -- 2013 Morningstar Advisor WorkStation/Franklin Templeton Data Center.