Don't Let Interest Rate Risk Keep You Out Of Fixed Income

by: Columbia Threadneedle Investments

By Columbia Threadneedle Investment Team

The bond market isn't devoid of risk. But different types of risk present themselves at different times, creating opportunities.

Fixed income investors tend to focus on interest rates and worry that when interest rates rise, the value of bonds goes down. But interest rates are just one aspect of the market, and the concern that they are rising shouldn't keep you out of the market completely.

Looking at what happened to investors from 2008 to 2016 reinforces that lesson. When rates went very low in 2008, investors worried that they had nowhere to go but up, so they scaled back allocation in the fixed-income market. In 2013, the Fed started to scale back its quantitative easing programs, which prompted a further retreat. Investors then allocated with vigor in 2016 - to the tune of $114 billion in net flows.1 Then, in December 2016, the Fed inched rates upward.

The rate movement, coupled with the uncertainty from a surprise outcome in the presidential election and inflation fears, nudged fixed income to become more volatile than equities. The end result for these investors? They didn't fully capture the strong returns from 2008 to 2016 but went back in the market just in time for the Bloomberg Barclays U.S. Aggregate Bond Index to post the worst quarterly return since the 1980s.

There's an alternative to this thinking, which is that exposure to interest rates isn't the only way to make or lose money in fixed income. There are three additional risk factors that create investment opportunities. Understanding when and how to leverage each one can help generate consistent investment outcomes.

Credit risk

There are some parts of the bond market, such as high-yield bonds or floating-rate loans, where interest rate risk is less of a factor. In these areas, it is often credit risk that is the dominant issue. This concerns the likelihood of default - the chance that a bond issuer won't pay its interest payments or repay the principal when a bond matures.

Exposure to credit risk can be beneficial when the economy is healthy and companies are growing strongly, but this type of exposure can hurt when growth sours.

Inflation risk

Inflation is something that historically has been the enemy of bond investors. However, some bonds adjust for rising inflation, such as Treasury inflation-protected securities (TIPS).

This part of the market generally does well when economic growth is accelerating and prices are rising, but it performs poorly when there's a lot of slack in the economy, which puts downward pressure on prices.

Currency risk

Currency risk is an important element for any U.S.-based investor buying into global fixed-income markets, and it is driven by changes in exchange rates. Currency volatility can have a profound impact on returns.

Exposure to foreign currency risk tends to perform well when economic growth and monetary policy abroad are attractive for investing overseas, but it performs poorly when the U.S. dollar is strong.

Balancing the risks for consistent outcomes

Investing in bonds involves awareness of several different types of risk, especially as many investors still under-appreciate the level of risk they're being exposed to. It's natural to associate a bond portfolio with safety, but even a bond portfolio could be aggressively credit-sensitive. Alternatively, it might be based on a global investment strategy, which - without the investor realizing it - carries high exposure to currency risk.

The different risk factors are not highly correlated to each other, so each element can be balanced against the others. There is almost always an area of the market that can generate a return, given the prevailing market conditions, while also protecting portfolios from the detrimental impact of, say, rising rates or a challenging credit cycle. If it's not interest rate risk, it might be credit; if it's not inflation, it might be currency.

Bottom line

It's important to develop a balanced bond strategy that takes into account each risk factor. Having a flexible approach to navigating these risks can help deliver a consistent total return over the course of a market cycle.

1 Source: Morningstar, U.S. fund intermediate-term bond category. Data as of 12/31/16.

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