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This past week delivered investors a lesson that has been taught over and over since public capital markets began: Buy the rumor, sell the news. Everyone knew QE3 (the third major "quantitative easing" program) was likely to be formalized after Gentle Ben practically said so at Jackson Hole. When the magic moment arrived, with the announcement of a $40 billion mortgage buying program (new money) and the extension of a program to reinvest principal proceeds from existing holdings (about $45 billion per month), Treasury Bonds immediately sold off. The yield of the 30-year Treasury ended the week at 3.09% compared to 2.92% the day before the FOMC announced its policy and 2.82% at the beginning of the week.

While this may have surprised many, it shouldn't. I shared my bearish views on interest rates just before the news, suggesting that it's time to minimize interest-rate risk after a 32-year bull market. I posted several ideas regarding how one might reposition one's portfolio, including discussing specific asset classes and sectors of the stock market. Today, I want to extend my analysis by focusing specifically on portfolios that are constrained by income requirements. If rates are going to remain quite low but are going to be rising, which is my view, then certain income-producing investments are likely to fare better than others.

Before I go on, I want to be clear about what I am suggesting. In my article about rates potentially rising, I received several comments about how difficult this would be given what the Fed is saying. After all, they are all but guaranteeing "low rates until 2015." It's true that short-rates, which are controlled by the Fed, are likely to stay quite low (unless the global economy miraculously reinvigorates itself). I am talking about longer-term rates, and this may be quite confusing to many who aren't familiar with the bond market. The Federal Reserve, through quantitative easing, is influencing long-term rates, but it doesn't control them. My bearishness comes in part because their actions and expected actions (from QE3) have already left longer rates lower than they should be. It's not widely recognized, but interest rates ultimately rose during both of the prior QE actions.

Ultimately, it comes down to this: bonds are one of the few assets that are not correlated with "risk assets". For all of 2011, bonds and gold traded as if they were one and the same by offering a "safe haven" from stocks, though this has been anything but the case for most of this year. What's going on now is actually the norm, while 2011 was the aberration, as typically the price of gold is positively correlated to inflation expectations while the price of bonds is negatively correlated. In the chart below, I compare the iShares Treasury 20+ Year Bond ETF (TLT) and the SPDR Gold Trust (GLD):

(click to enlarge)

As the debt ceiling talks fell apart and concerns about Europe flared last summer, both moved dramatically and in the same direction, reflecting investors' need to hedge "tail risk" in my view. How the financial pressures around the world ultimately play out is unknown to anyone - they could lead to huge deflation or massive inflation. Or, most likely, something in between. More recently, things have normalized, with the price of bonds and the price of gold moving inversely. It was especially pronounced last week.

The bear case on Treasuries is basically that the world is not ending. I believe that QE3 will be just like the other programs and ultimately not lead to lower long rates. The pro-inflationary bias that is being seen in rallying gold and other parts of the markets reflects a fear with which I concur: overshoot. Right now, our economy (and most other economies) is quite weak. It would be a mistake to think that marginally lower rates will have much, if any, impact, but perhaps the economy improves for other reasons. There is a large fear that the Fed could be too late to withdraw liquidity. The bear case for bonds is normalization of interest rates. If the economy actually does grow strongly, it would be an absolute disaster for bonds. I am not in that camp, but it is a risk.

While it's clear to almost everyone that Treasuries are expensive, what's not known is how other income-producing assets account for this phenomenon. There is little reason to think that the yield on all fixed-income or equities will rise one for one with any potential increase in interest rates, though it's unlikely that there won't be an impact. All investors should care about this risk, as it could result in capital losses as well as the opportunity cost of better yields in the future. I will now address specific parts of the bond and stock market and assess the likely impact of higher interest rates.

Bond Market

The bond market, broadly defined, would include Treasuries (and Agencies), Mortgages and Corporates. High quality Corporates are included in the most common benchmark, the Barclays Aggregate Bond index, while lower quality bonds (also known as "Junk" or "High-Yield") are not. One of the most popular ETFs is the iShares Barclays Aggregate (AGG), and this is an affordable way to passively own the entire bond market. There are several ways to own the components. The other popular ETF for bonds would be high-yield, including the iShares High Yield Corporate Bond ETF (HYG) and SPDR Barclays High Yield Bond (JNK). Beyond ETFs, there are many mutual funds as well, and, of course, one can always invest in bonds directly. So far, we have discussed just domestic bonds, though there are many ways to invest in foreign bonds as well, including developed and emerging economies.

If you are concerned about the risk of rising interest rates, you can take several steps to reduce your exposure. The main issue is to sell longer-maturity Treasuries and bonds from other sectors that will likely track longer-maturity Treasuries closely. Here are some specific ideas to consider:

  1. Sell Treasuries longer than 5 years
  2. Sell Corporates longer than 7 years
  3. Increase exposure to Mortgages
  4. Increase exposure to High-Yield
  5. Consider floating rate debt
  6. Consider non-U.S. bonds

The price risk by definition is greater for bonds with longer maturities, but the current environment makes it even more the case. With the Fed likely to keep shorter rates low for a long time, even as the economy is potentially improving, longer rates could rise while shorter rates remain relatively constant. This is known as a steepening of the yield curve. If you hold a 10-year Treasury and interest rates rise by 1%, you would lose approximately 9% if you needed to sell. You can avoid this kind of risk by shortening, but it comes with a cost. The 10-year Treasury yields 1.87%. If you move to the 5-year, your yield drops to 0.71%. Obviously, if you move to cash, it drops to close to zero. Your strategy will be dictated by how strongly you feel about the risk of rising rates.

The math works generally the same with corporate bonds, though the higher yield (the spread) gives you a little more cushion. This is why I suggest cutting maturities to 7 years rather than 5. The higher quality the bond, the more it will track a Treasury. So, this is an area where you need to be concerned if you want to reduce interest-rate risk in your portfolio.

Mortgages are very interesting now. Recall that this is where the Fed is buying. In fact, the iShares Mortgage Index (MBB) didn't really change in price. I own MBB in my Conservative Growth/Balanced Model Portfolio. Let me explain why. That model is measured against 60% stocks and 40% bonds (the Aggregate Index, which includes MBB plus a Government and Corporate component). With mortgages, one gets significantly more yield but a shorter expected maturity, but it comes at a cost. While interest-rate risk for smaller moves is less than the overall bond market, mortgages have embedded options. Because homeowners have the option to refinance when rates drop or to never refinance and pay off over the term, mortgages go away when rates drop and stick around when they rise. So, for very large interest rate increases, investing in Mortgages might not be wise. If, like me, you expect a more moderate rise, the extra yield and shorter maturity could mitigate price-risk.

High-yield could be a great alternative. It's not the bargain that it was, but, in an improving economy that leads to higher interest rates, the sector could benefit from lower defaults. Typically, the spread narrows (this is the difference between the yield of the high-yield bond and the Treasury), so the price risk should be less. Additionally, the higher income can mitigate the price-risk.

I have to admit that I am not so up on the vehicles in which one can buy floating rate debt, but I wanted to pass the concept along. Floating-rate debt exposes one to credit risk but not interest-rate risk. The quality is actually pretty low for most funds, as they are investing in bank debt. If short-rates rise, the owner will receive more income. If short-rates don't really move but longer rates rise, one can then sell the floating-rate debt and take advantage then of higher longer-term rates at that time. In a stronger-economy scenario, this is likely a good idea, but, like high-yield, there is price risk if the economy is weak due to the potential for defaults as well as wider spreads on the holdings of the fund. I sure hope that those more familiar than I am with specific offerings will share their ideas in the comments below, but I will share an unnamed example that I think captures the idea well. This mutual fund, which has a 0.7% expense ratio, has over $5 billion in assets. The current yield is 3.7%.

Finally, international bonds can play a role in income generation while diversifying. Again, for me, this is an area in which I am more familiar with the concepts than the exact details. Many emerging market countries have better financial positions than the developed countries. With any international bond, there is always some level of political risk, and it's certainly higher with emerging countries. Still, while our rates are low and possibly rising, many international bond yields are high and falling. We have been in a 32-year bull market, but some emerging markets (and developed, like Spain and Italy, for instance) have been in bear markets. An additional consideration is that there is currency risk. Of course, changing currency rates can work for or against the buyers of international bonds. Again, this is really conceptual, but, the big takeaway should be that this could be an area worth exploring for income generation. I do have a specific example to share, which is a closed-end fund, the Templeton Global Income Fund (GIM), but there are many mutual funds with the same mission of generating high current income. The fund had its IPO in 1988 at $10 and trades just below NAV at 9.23. The current monthly dividend is .035 per share, a reduction from where it had been but still a yield of about 4.5%. For the overall emerging market, according to Barclays data, the yield is currently 5.26% compared to the Aggregate Bond index at 1.78%, with similar interest-rate risk.

Summing it up, income investors face many challenges in our current environment of generational-low interest rates. Some have taken either credit risk, liquidity risk, or maturity risk in order to help offset the reduction in yields. The stock markets around the world are in rally mode, perhaps signaling economic improvement in the future. Income investors need to understand that as interest rates normalize, many income-oriented securities face potential price declines, some more than others. In this first part, I have discussed how the unfolding changes could impact various parts of the bond market. Shortening maturities to protect from potential capital loss results in less income, but, in an improving economy, income-oriented investors can assume more credit risk to maintain overall income. In Part 2, I consider income-producing equities, an area where income-oriented investors should focus as well.

Source: Managing Interest Rate Risk In An Income-Oriented Investment Portfolio (Part 1)

Additional disclosure: The author owns MBB in one or more of the model portfolios he manages at InvestByModel.com