The recent rise in interest rates has many bond investors on edge, particularly regarding its impact on the fixed income allocation within a diversified portfolio. In some cases, investors are making wholesale shifts, swapping the interest rate risk of a fixed-rate payment for credit risk (of, for example, a floating-rate payment). But is that the best approach to mitigate interest rate risk? Below, I’ll address how average investors can position their portfolios for a rise in rates through strategies that use common exposures—and don’t require a complete portfolio repositioning.
Looking Beyond Duration
When investors express concern over the price impact that rising interest rates have on their portfolios, they’re typically referring to interest rate risk—the potential for bond prices to drop when interest rates rise. This risk is often measured by looking at a fixed income instrument’s duration (i.e., a calculation of its sensitivity to interest rate changes). For instance, if an instrument’s duration is five years, then a parallel move up in rates of 100 bps (i.e., a 1% rise in rates) should translate into a 5% loss for the portfolio, all other relevant factors being equal.
While applicable in theory, this so-called hard duration measure is too simplistic when assessing interest rate risk for a portfolio. It doesn’t do a very good job of addressing exposures in a holistic context. Hard duration is a better metric for assessing the price impact of interest rates on a single security, such as a U.S. Treasury bond, than on an entire portfolio or mutual fund with multiple exposures. Why? Most portfolios include an array of exposures (diversification!), which, when combined, can do a fairly good job of mitigating interest rate risk, just as traditional diversification does.
Let’s take a closer look.
Spread-Oriented Exposure
Historically, long-term Treasury securities have come with the strongest interest rate risk. But spread-oriented products—corporate bonds, mortgages, high-yield investments, and bank loans—often have many other characteristics that influence how the particular security trades.
For example, investors should be aware that:
• 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 issues in the high-yield space, have historically exhibited a positive correlation with an increase in rates, recording a stronger link to equities than to Treasury securities over time.
• When the economy improves and interest rates move higher, many lower-quality securities get upgraded (moving, for example, from a BBB- to an AA- rating), which results in an increase in their price.
Consider a mutual fund that holds AAA and BB bonds in an improving economy associated with rate increases. In this situation, there would certainly be downward pricing pressure on the portfolio’s AAA securities due to interest rate sensitivity and their Treasury-like credit quality. At the same time, some issues in the lower-quality BB space would most likely be upgraded as general economic fundamentals improve. Overall, the fund’s volatility would likely be mitigated, with some securities (e.g., higher-quality bonds) seeing downward price pressure and others (e.g., lower-quality bonds) experiencing upward movements in price.
Strategic approach. Invest in fixed income mutual funds that hold a diversified combination of spread-oriented sectors in an effort to reduce the interest rate sensitivity of their portfolios.