How Do Rising Rates Affect Bond Investments?

Posted by Peter Essele, CFA, CAIA, CFP

This entry was posted on Dec 18, 2015 3:00:00 PM

and tagged Investing

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InterestRates_5-1.jpgMy colleague Peter Essele, portfolio manager in Commonwealth’s Investment Management group, is the author of today’s post, which was originally published in June 2015. With so much focus on the Federal Reserve and rising rates, it is a good reminder.

Though the media want us to believe that we’re on the verge of a cascading bond market—where rising rates will lead to price declines on bond strategies, which will lead to outflows, followed by more price declines due to forced selling—these fears are somewhat exaggerated.  

To insulate portfolios against a cascading bond market event, many investors have assigned larger and larger portions of their interest-rate-sensitive fixed income allocation (i.e., core fixed income) to multisector or nontraditional bond strategies, such as Fund Company A’s Strategic Income portfolio or Fund Company B’s Unconstrained Bond. In the resulting allocation, core fixed income (Treasuries, agency mortgages, investment-grade corporate bonds) has been replaced largely with high-yield bonds, bank loans, and other below-investment-grade securities.

What they are doing is shifting from high-quality duration risk to credit risk. But is it smart to do so?

Credit and duration risk

It turns out that the average below-investment-grade exposure for managers in the nontraditional category is roughly 50 percent, according to Morningstar Direct. In the multisector category, the exposure is similar, at 48 percent. This means that investors who have moved away from core fixed income into a cluster of go-anywhere managers like those mentioned above have a fixed income allocation that, on average, is 50 percent high-yield.

That’s a fair amount of credit risk in a portfolio, especially when you consider that high-yield is highly correlated to equities. Why? In short, both have very little claim on assets in the event of bankruptcy and liquidation of assets, and both often see very similar price movements, despite being issued in different forms.

It's not the bus you're looking at that hits you

For argument’s sake, let’s say that the economy begins to enter a bit of a soft patch now that the Fed decided to raise rates. Risk-off trades may permeate markets as investor sentiment wanes and storm clouds begin to form. Equities start to slide, and high-yield follows suit.

When I present this scenario, it’s often followed by the same remark: “That’s why I hired a manager with a flexible mandate.” To which I typically respond, “Yes, but will that manager be able to navigate markets when liquidity dries up and forced selling ensues?”

It’s not a pretty picture, especially for a bond portfolio with 50 percent allocated to high-yield, one of the least liquid areas of fixed income.

Based on my recent conversations, it’s clear that investors are focused on downside from duration risk, but net asset value declines from credit risk aren’t on their radar. Looking at the data, however, you could argue that there’s greater risk in the latter. Just imagine a scenario where investors begin to see price declines on their conservative, go-anywhere bond investments at a time when their equity allocation is also moving lower. What would act as the ballast?

Duration is certainly something to consider, but credit risk is the bus coming from the other direction.

There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.

Duration quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio should be to changes in interest rates.

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