With the Federal Reserve expected to start raising rates as early as next month, one question has been top of mind for many advisors: "What's the best method of protecting portfolios against rising rates?"
But I think there's another question you should also be asking: "How should you go about assessing interest rate risk?" Hint: not all bonds are created equal. (Be sure to look beyond the sacred duration measure represented in Morningstar®.)
To help answer each of these questions, let's take a deeper look into one of the basic tenets of portfolio construction: assessing portfolio exposures through a holistic lens rather than viewing them in isolation.
When your clients express concern over the price impact that rising interest rates may have on their portfolios, they are typically referring to interest rate risk—often measured by a bond's duration. For instance, if a bond's duration is measured as 5, then a 100-basis-point (i.e., 1-percent) parallel move higher in rates should theoretically translate into a 5-percent loss for the portfolio, ceteris paribus.
This is true in theory, but this so-called hard duration measure is fairly simplistic and doesn't adequately address exposures in a holistic context. It 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. Why? 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.
3 Exposures to Reduce Interest Rate Sensitivity
To help protect your clients' portfolios from rising interest rates—and provide a holistic approach to assessing this risk—here are three exposures you might consider:
1) Spread-oriented exposure. One way to potentially reduce a portfolio's interest rate sensitivity is to allocate a portion away from Treasuries and into spread-oriented sectors. Although it can be argued that Treasury securities have the strongest interest rate risk, spread-oriented products (e.g., corporate bonds, mortgages, and high-yield investments) often have many other characteristics that influence how a particular security trades. So, 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.
In fact, corporate bonds, especially lower-quality names in the high-yield space, have historically exhibited a positive correlation with an increase in rates. Over time, they have also recorded a stronger correlation to equities than have Treasury securities, 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 results in an increase in price.
For example, 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 pricing pressure on the AAA securities in the portfolio because of interest rate sensitivity and Treasury-like credit quality.
- Some names in the BB space would most likely be upgraded as fundamentals improve.
- As a result, there would be a mitigating effect in the fund, with some securities seeing pricing pressure and others experiencing upward movements in price.
2) Global exposure. Another means of protecting portfolios against rising rates is through the use of foreign fixed income securities. It's unlikely that interest rates around the world would all rise at the same time, affecting securities in the same fashion. Although 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, what if Brazilian yields were to rise as a result of inflationary pressures at a time when Singapore was entering a recession? Given this scenario, an income portfolio could experience a decline on the Brazilian position and a corresponding increase from the exposure to Singapore sovereign debt. This would effectively net out any price impact from a move in rates.
3) Equity exposure. When markets experience a rate increase, it's generally in response to inflationary fears and an expanding economy. If the economy expands 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 expand beyond historical levels. Barring a wildly inflationary environment, equities can represent an attractive asset class in rising rate environments and help offset any losses that may be experienced in fixed income positions within a portfolio.
Further, because of the low correlation between equities and interest rate-sensitive securities, allocating a portion of a portfolio to domestic and international equities that offer attractive yields can do two things:
- Potentially help preserve the real value of the portfolio
- Mitigate fixed income pricing pressure in the face of modest inflation and a rise in rates
The Big Picture
If you were to aggressively insulate the fixed income portion of a 60/40 portfolio against a rise in rates, you would, in effect, correlate the entire portfolio and remove the so-called risk-off downside protection. This could be potentially disastrous during a credit event similar to that of 2008, when risk assets sold off precipitously. On the other hand, you could use the various exposures discussed here, taking a holistic approach to assessing the overall interest rate sensitivity of a portfolio. By doing so, you'll have a better view of the big picture—focusing on the forest rather than the trees when making allocation decisions.
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Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved.
Special risks are associated with foreign investing, including currency fluctuations, economic instability, and political developments.
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