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As head of BlackRock’s Multi-Asset Portfolio & Investment Consulting team, I get a courtside seat to investor trends. Since the Fed’s tapering announcement last May, many investors have been extremely worried about how rising interest rates will affect their portfolios. Unfortunately, in their quest to “Fed-proof” their fixed income investments, some investors are unintentionally taking on other types of risk — and in doing so, losing diversification and increasing their exposure to volatility.

Let’s imagine an investor with a portfolio entirely in traditional bonds — say the Barclays US Aggregate Bond Index, which has a duration of 5.25 years and a yield-to-maturity of 2.15%. In the current market environment, with rising rates likely on the horizon, the investor might not want to be too far out on the yield curve, as the price of longer-term bonds can decrease and the investor will likely lose money if she sells her long-term bonds before maturity. She decides to shorten her duration by introducing shorter-term investment grade bonds. But the shorter duration means a lower overall yield, so she might want to offset the yield loss by taking on higher-yielding bonds, as shown below.

(click to enlarge)

The investor is able to keep roughly the same original yield while shortening duration by over one year. Sure, she knows that a high yield investment carries more risk than investment grade bonds, but she thinks that allocating only 15% shouldn’t make a big difference in her overall portfolio. However, is this truly the case?

There are two main problems with the new allocation:

  1. It increases correlation to stocks1. One of the most important aspects of fixed-income investing is that it helps diversify the portfolio from the behavior of equities. But this is not true for all bonds. The returns of a high yield index, such as the Markit iBoxx USD Liquid High Yield Index, have a correlation of 0.74 when compared to the Russell 3000 Index — even a 15% percent high-yield allocation will increase the original portfolio’s correlation to 0.42. This is a considerable jump from where it was before — zero on a historical basis.
  2. It increases sensitivity to credit spreads2. Investors adding high-yield bonds expose themselves to greater credit risk — that is, the chance that spreads will change between securities and their reference points (like Treasuries). The 15% addition of high yield to the portfolio leads to almost a four-fold increase, from -0.41 to -1.60, in sensitivity to credit spreads, increasing the risk that the investor could lose money.

As illustrated through this example, by adjusting the bond allocation the investor’s portfolio loses part of its value as a diversifier and risk dampener. If you want to lower exposure to interest rate risk while trying to keep yield unchanged, you will likely have to increase your credit risk.

While it’s easy to focus on headlines and forget the primary purpose of fixed income in your asset allocation, it’s important to consider the role of bonds in your portfolio in advance of such changes. Focus on risk and return trade-offs, otherwise you may find yourself running into unintended risk.

1,2Correlations and sensitivity to credit spreads are calculated from the inception of the Markit iBoxx USD Liquid High Yield Index to last quarter-end (11/1/2006 to 3/31/2014).

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Source: Trying To 'Fed Proof' Your Portfolio? Beware Of The Risks