Presented by Bruce Horowitz
The strong equity market rally in early 2013 has fueled some concerns about inflation and rising interest rates, and investors now may be wondering how they can protect the fixed income portion of their portfolio against this inevitable rise in rates.
It’s important to remember, however, that not all fixed income instruments are created equal, so you need to assess your portfolio’s exposures through a holistic lens rather than view positions in isolation or even in clusters, such as equity versus fixed income.
Beyond hard duration
When investors express concern over the price impact that rising interest rates have on their portfolios, they are typically referring to interest rate risk, which is often measured by a fixed income instrument’s duration. For instance, if a fixed income instrument’s duration is 5, then a 100-basis-point (i.e., 1-percent) parallel move higher in rates should translate into a 5-percent loss for the portfolio, all else being equal.
Although this is true in theory, this so-called hard duration measure is fairly simplistic and does not do a very good job of addressing exposures in a holistic context. Hard duration is often a better metric for assessing the price impact on a single security, such as a U.S. Treasury bond, than on an entire portfolio. This is because portfolios often include an array of exposures, which, when combined, can do a fairly good job of mitigating interest rate risk in the traditional sense.
Let’s take a closer look.
Although Treasury securities historically have had the strongest interest rate risk, spread-oriented products—corporate bonds, mortgages, and high-yield investments—often have many other characteristics that influence how the particular security trades.
A movement in Treasury rates one way or the other doesn’t always translate into a corresponding movement in price based on a stated duration.
- Corporate bonds, especially lower-quality names in the high-yield space, have historically exhibited a positive correlation with an increase in rates and have actually recorded a stronger correlation to equities than Treasury securities over time, especially in periods of turmoil.
- When the economy improves and interest rates move higher, many securities tend to get upgraded, such as a movement from BBB- to AA-rated, which generally results in an increase in price.
Consider holding AAA and BB bonds in an improving economy associated with rate increases. In this situation, there would certainly be pricing pressure on the AAA securities because of interest rate sensitivity and Treasury-like credit quality, though some names in the BB space would most likely be upgraded as fundamentals improve. This could result in an overall mitigating effect in the overall portfolio, with some securities seeing pricing pressure and others experiencing upward movements in price.
As a result, investors may want to consider moving a portion of their portfolio out of Treasuries and into spread-oriented sectors in an effort to help reduce the portfolio’s interest rate sensitivity.
Another way investors can reduce the interest rate sensitivity of a portfolio is through the use of foreign fixed income securities. It seems unlikely that interest rates around the world would all rise at the same time, affecting securities in the same fashion. Even though markets are becoming more integrated, a fair amount of segmentation still exists, and correlations among rates in various developed and emerging countries are still somewhat muted.
For instance, if Brazilian yields were to rise as a result of inflationary pressures at a time when Singapore was entering a recession, a portfolio could experience a decline on the Brazilian position and a corresponding increase from the exposure to Singapore sovereign debt, effectively netting out any price impact from a move in rates. Please keep in mind international investing presents its own risks including currency fluctuations, economic or financial instability and lack of timely or reliable information or unfavorable political or legal developments.
Generally, when markets witness an increase in rates, it is in response to inflationary fears and an expanding economy. If the economy is expanding at a healthy pace, this usually coincides with a movement higher in equities as earnings growth accelerates, investors become more confident in the environment, and price multiples may expand beyond historical levels. Barring a wildly inflationary environment, equities can represent an attractive asset class in rising rate environments and help to offset any losses that may be experienced in fixed income positions within a portfolio.
Because of the low correlation between equities and interest rate-sensitive securities, investors may want to consider increasing their allocation to domestic and international equities that offer attractive yields, which can help preserve the real value of the portfolio and help mitigate fixed income pricing pressure in the face of modest inflation and a rise in rates. Of course, equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.
Looking at the big picture
In conclusion, the most appropriate approach to assessing the overall interest rate sensitivity of a portfolio is to look at it in a holistic context rather than take a segmented view of equity and fixed income sleeves in isolation. In other words, it’s important to focus on the forest rather than the trees when making allocation decisions.
We are committed to allocating your portfolio in a way that takes advantage of economic changes but is also in line with your investment risk profile and overall financial plan and goals.
Bonds are subject to availability and market conditions. Generally, the bond market is volatile, bond prices rise when interest rates fall and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income. Corporate Bonds contain elements of both interest-rate risk and credit risk. Government Bonds are guaranteed only as to timely payment of principal and interest and does not eliminate market risk.
IMPORTANT NOTE: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Due to industry regulations, comments are not permitted on this blog. If you would like to contact the author, please email us at firstname.lastname@example.org
© 2013 Commonwealth Financial Network®