The Independent Market Observer

What Happens to My Bond Investments When Rates Rise?

Posted by Peter Essele, CFA®, CAIA, CFP®

This entry was posted on Jun 26, 2015 12:17:00 PM

and tagged Investing

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interest rates and bond investmentsToday’s post is from my colleague Peter Essele, portfolio manager in Commonwealth’s Investment Management group. See you next week! — Brad

I’d say that nine out of ten questions I’ve fielded recently are some variation on the title of this post. Many people seem to think that the impending rise in rates will have a kind of snowball effect on bond markets—that rising rates will lead to price declines on bond strategies, which will lead to outflows, followed by more price declines due to forced selling, and then more outflows.

The result, many believe, would be a cascading bond market (possibly akin to Donald Trump’s presidential poll ratings over the next six months).

To insulate portfolios against this type of 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 fixed income allocation, core fixed income (Treasuries, agency mortgages, investment-grade corporates) has been largely replaced with high-yield, bank loans, and other below-investment-grade securities.

Basically, it’s a move from high-quality, duration risk to credit risk.

But is it a smart move?

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 slightly lower, 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 are running with a fixed income allocation that is 50 percent high-yield, on average!

That’s a fair amount of credit risk in a portfolio, especially when you consider that high-yield has a very high correlation 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, it's the one you don't see . . .

For argument’s sake, let’s say that the economy begins to enter a bit of a soft patch in the third or fourth quarter and the Fed decides to postpone the rate hike until 2016, waiting for more clarity on the labor and inflation fronts. In the meantime, risk-off trades begin to 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 NAV 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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