We know that an interest rate hike by the Fed, which we think will happen either during their June or September meeting, could impact your fixed income investments. Fed action will push up short-term interest rates, and will likely impact medium-term interest rates as well. Longer maturity bonds should be less impacted by Fed action, but yields on these securities are also near historical lows due to a global slowdown in growth and inflation, and active buying of bonds by central banks in Europe and Japan. Many investors are concerned about what might happen to their bond portfolio when these trends reverse and rates rise. At the same time many investors are struggling to find yield. With the yield on the 10-year US Treasury hovering around 2%, investors have been looking to riskier asset classes, such as high yield and emerging markets, to seek income. (Source: iShares flows data; Bloomberg.) This leaves many investors wondering whether they are taking on too much risk.
The efficient portfolio approach
One way to approach this problem is to think about what a risk efficient portfolio might look like. By risk efficient I mean a portfolio that provides potential income without taking on too much risk to do so. Within the bond market, we find the majority of performance is driven by two separate types of risk: interest rate risk and credit risk. Interest rate risk is the risk that a rise in interest rates will drive down the price of your bond or portfolio. Credit risk is the risk that the bonds that you invest in will default and will fail to make their scheduled coupon or maturity payments. Bonds like U.S. Treasuries have no credit risk but are subject to interest rate risk. Others, like corporate bonds, carry both interest rate risk and credit risk.
Here are two things you need to understand about credit risk and interest rate risk.
- An investor is generally paid for taking on these risks. If you buy a short-term Treasury bond you are taking on only a small amount of interest rate risk, and in return you will receive a small amount of yield potential. Buy a longer maturity Treasury and you are exposed to more interest rate risk but are generally paid for it in the form of higher yield potential. Similarly, a high quality corporate bond should provide yield to compensate an investor for credit risk, and a low quality corporate bond typically pays a higher yield as it carries more credit risk.
- Historically, credit risk and interest rate risk have had a negative correlation. (Source: Barclay's Index data, 1988-12/31/2014.)* This means that often when one of them is rising, the other is falling. Thus having both credit risk and interest rate risk in your portfolio can provide diversification. The two risks help balance each other out.
To this end we recently introduced the iShares U.S. Fixed Income Balanced Risk ETF (BATS:INC). The fund strives to maintain an equal amount of interest rate risk and credit risk, which may provide higher risk adjusted returns. Relative to a commonly used core fixed income fund like the iShares Core U.S.
The FIBR Strategy Target for illustrative purposes only. Uses monthly Barclays Index Data between August 1988 and December 2014; interest rate risk was 92% of the Barclays Aggregate's total risk. Excess returns were used to proxy spread risk. Total Returns-Excess Returns were used to proxy interest rate risk.
Aggregate fund (NYSEARCA:AGG), INC has less interest rate risk and more credit risk. This results in INC having a potential higher yield, but that yield is compensation for having more credit risk. It also means that INC has less interest rate risk than AGG, and may be less impacted by a rise in rates. INC aims to balance the credit risk with the interest rate risk in the portfolio.
Considerations for your own investing strategy
Which is the right solution for you? It really depends on what you are trying to achieve with your fixed income investment. Interest rate risk is a good diversifier against equity risk. If you are looking for your bond investment to provide ballast against your equity holdings then AGG may be more appropriate. If you look to your fixed income investment to provide some ballast, but also a bit more income potential, then INC may be more appropriate. As always, the key is that you now have another option to help you build the right portfolio for you.
Index or Active?
At this point some readers may be wondering how to categorize INC. Is it index? Is it active? We classify INC as smart beta. Much like the smart beta funds that have grown in popularity in equity markets, INC seeks to improve risk adjusted returns in a transparent, rules-based, low-cost way. My colleague Sara Shores discusses this concept on the Blog and will take a closer look at smart beta fixed income solutions in the coming weeks.