What To Expect From A Rate Increase On Your Fixed Income Portfolio

|
Includes: AGG, ARDC, BHK, BND, BOND, BTZ, DBL, EGF, FBND, FTT, GBF, GOVT, ICB, IPE, IUSB, JHI, JMM, LTPZ, PAI, PCM, PLW, PTY, RA, RCS, SAGG, SCHP, SCHZ, SIPE, SPAB, STIP, STPZ, TAI, TAPR, TDTF, TDTT, TIP, TIPX, TIPZ, TPS, VBF, VBND, VTIP
by: Sean Dalton

Summary

The Federal Reserve is looking to raise interest rates this year.

While the timing of the rates is still undecided, raising rates could lead to a chain reaction of more rate increases or decreased economic growth.

How will different fixed income securities react to the raise in rates, and what should investors be concerned with?

As the Federal Reserve's June Open Market Committee (FOMC) rapidly approaches, the question on everyone's minds is if the Fed will stand firm on its projections to raise interest rates this year. Only 3% of the economists in a Wall St. Journal survey believe that the Fed will raise interest rates as early as this month; 72% of those polled believe that the rate increase will indeed come this year, with the majority believing that the rate increase will come in September. While a rate increase is certainty not a surprise, there are many who are still calling for more caution and time in delaying the rate. Time will tell when precisely the Fed will raise rates, but fixed income specialists are already working to decipher what it will mean for the sector.

The Fed has kept rates near zero since the end of 2008 in an attempt to help support the economy through the financial crisis, recession and a slow recovery. However, with a relatively strong showing in the retail sector, along with the further improvement of the labor market and the anticipation of inflation moving to the 2% range, the market seems strong enough to survive a rate hike of low to moderate proportions. However, even this point is currently being disputed. Some insiders believe that the rate hike is already late due to the policy lag timing, with the perception that the Fed should have already raised rates in an attempt to time the lag in implementation with the economy's recovery. Historically, the Fed has raised rates 35 months after the recession of 1990 and 32 months after the recession of 2001. The Fed has, since December 2008, refused to raise interest rates in the last 72 months, more than the delays of the other two recessions combined.

*Recession peak Recession trough Lift-off month Months after lift-off
July 1981 Nov. 1982 May 1983 7
July 1990 Mar. 1991 Feb. 1994 35
Mar. 2001 Nov. 2001 Jun 2004 32
Dec. 2007 Jun. 2009 ?

72+

Other supranational organizations such as the World Bank have instead argued that the Fed should delay its rate increase, citing the fact that tightened monetary policy could strengthen the dollar and slow the already uneven growth in the economy, as well as causing trouble in emerging markets. This, compounded by the fact that the World Bank has already cut its growth projections for global growth from 3% to 2.8%, shows that even among professionals there is no consensus of when a rate increase would be the most effective.

Regardless of the arguments for and against the timing of the rates, the general consensus of the Fed appears to be that an eventual rate increase will be necessary for the stabilization of the economy. Having not raised rates above the 0.00%-0.25% range in over six years, and based on the multiple arguments on the proper timing of the rates, it's generally expected that if FOMC were to agree to raise rates this year, it would be by a very low and manageable amount. If we take FOMC's actions in the wake of the 2004-2006 rate hike as precedent, the Fed raised rates 17 times over the three years, by 25 basis points (0.25%) each time, giving the market ample time to adjust, adapt and anticipate the rate increase so as to ensure that it would not hamper the economic growth over the period.

The question on investors' minds, then, is how would the rate increase affect their portfolio and the different fixed income securities within it. Although not substantial, an increase in interest rates would be consistent with an increase in the market discount rate, decreasing bond prices across sectors. For bonds with the same time-to-maturity, a lower coupon bond will have a greater percentage price change than high coupon bonds, and for bonds with the same coupon rate, the increase in rates will cause a greater price change in longer-term bonds due to increased reinvestment risk. Regardless of the specifics of the bonds, the duration of fixed income products should increase, as the weighted average of the payments of a fixed income security will be discounted at a greater rate and take longer to accrue.

The price and YTM of Treasuries should fall, with the market now compensating above what the already-issued treasuries are yielding to investors. While the estimated change is low, short-term treasuries will be least affected by the rate raise as the Macaulay Duration is the shortest, but will still experience a decrease in demand due to a coupon rate and YTM less than the market.

US Government Linkers, such as the Treasury Inflation Protected Securities (TIPS), will be interesting to watch as a rate increase should decrease inflation expectations (and thus decrease the principal of the TIPS), but as inflation is still weak, this could prove to actually move to further disinflation, potentially reducing the principal of the current principal below its current value if the effect of the interest rate were to sink the already unsteady recovery. The market risk of these bonds should increase and should be clearly watched by investors.

Investment grade corporate bonds should drop in market price due to the reinvestment rate risk of the coupon payments as the market discount rate increases. However, this could provide a unique opportunity to investors whose portfolios comprised of bonds with Put options could find themselves in a unique position for a pay-off by being able to exercise the option and investing in short-term securities while the Fed raises interest rates by small incremental amounts over the next few quarters.

Finally, emerging market bonds would most certainty suffer as the appreciation of the dollar from the contraction in monetary policy would weaken their underlying economy by reducing imports and access to critical capital for production, but also because the strengthening dollar, would cause a desire to sell and an outflow of capital as investors scramble to reinvest domestically at the higher rate. The only hope that emerging market bonds have is to widen the spread on their bonds and compensate investors for the reduced liquidity.

Thus, with an increase in rates, and presumably a relatively successive chain of low increases, should reduce the price and duration of a fixed income portfolio while subsequently increasing the reinvestment risk and market discount rate of the fixed income valuations. While the exact date of the rate increase is still being debated behind the closed doors of the Federal Reserve, make no mistake that fixed income portfolio managers are already preparing for its implementation.

*Table Courtesy of MarketWatch

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.