Regardless of whether you live in Ventura, Calabasas, Simi Valley, or Moorpark; you are probably aware of the asset management challenges that exist in today’s fixed income markets due to rising interest rates. As it is well known, bond prices have an inverse relationship with the direction of interest rates. So, what asset management strategies can financial advisors, investment companies, and investors consider implementing to mitigate interest rate risk?
Lowering Interest Rate Risk with Short-Duration Strategies
One approach to mitigating bond price fluctuations in the face of rising interest rates is to lower duration (interest rate sensitivity). Duration, expressed in number of years, is a measure of a bond’s price sensitivity relative to changes in interest rates. As a bond gets closer to maturity, its relative percentage change in price movements becomes “less sensitive” to relative percentage changes in interest rates. Let’s walk through an example.
Let’s suppose you own a 10 year bond purchased at par ($1,000) paying a coupon rate of 4%. What is the percentage price decline in your bond value in 4 years and 9 years if interest rates are at 6%? So, four years later (with interest rates at 6%), you notice your bond is worth around $915.85, which represents an 8.415% decline. Now let’s look at that same bond 9 years later with interest rates at 6%.
So, 9 years later (with interest rates at 6%), you notice your bond is worth around $981.15, which represents a 1.885% decline. As a bond gets closer to maturity, its relative percentage change in price movements is “less sensitive” to relative percentage changes in interest rates. With this example, I am illustrating the secondary market’s pricing of your bond. Keep in mind, holding your bonds to maturity ultimately results in no realized losses.
Why Short-Duration Asset Management Strategies are Better Suited to Rising Interest Rates
Short-duration asset management strategies are better suited to benefit from rising interest rates for two reasons:
- They benefit from having less exposure to interest rate risk, as discussed above.
- They can adjust their yields in times of rising interest rates more quickly than longer-duration strategies. As a result, they are able to constantly reinvest their proceeds from maturing bonds into higher and higher coupon securities over time.
Let’s now look at some other strategies.
Investing in High Yield and Other Spread Financial Investment Products
High yield bonds and other spread-oriented securities are characterized as having lower credit ratings relative to safer investment-grade corporate and United States treasury bonds in terms of default risk. As a result high yield bonds and spread investment products have to offer investors premium yields above the less risky, higher quality issues (less risk of default). Other spread-oriented strategies usually consist of senior floating rate loans, preferred securities, asset-backed securities, and non-agency mortgage-backed securities.
There are two reasons why high yield bonds and other spread financial investment products usually do well in rising interest rate environments:
- Their price movements are more reflective of the credit health of the underlying entity and tied more to the overall wellness of the global economy. This factor has more of an impact on whether the underlying issuer can repay its obligations to bondholders. This is known as credit risk. Form an economic point of view, rising interest rates usually signals a growing economy and more competition in the credit markets. This usually provides a favorable back drop for credit sensitive investments.
- Because these investments pay a spread premium, there is potential that the premium spread can make up for any marginal declines in bond prices due to rising interest rates.
Floating Rate Financial Investments: What are They? How Do They Work?
Floating rate bonds are unique and particularly well suited for rising interest rates. So, how do they work? Floating rate financial investments are similar to high yield bonds, but pay an adjustable coupon (floating rate) that moves with interest rates. It is essentially a hybrid between short-duration bonds and high yield bonds. It is composed of two parts:
- A short-term resetting interest rate component (short-duration part), usually tied to some interest-rate benchmark like LIBOR.
- A fixed-rate (high yield) spread component above the floating-rate piece. This construction makes floating rate bonds very friendly to investors as interest rates rise.
Investing in Foreign-Oriented Fixed-Income Financial Investments
Another option for financial advisors, investment companies, and investors is to invest in globally-oriented fixed-income strategies. The thought process is to move exposure away from U.S. interest rate risk and the U.S. dollar (currency risk) by investing in different economies around the world. Interest rate cycles of foreign economies can vary and be largely independent of U.S. monetary policy. This can be especially true with emerging markets’ debt and currency, as they tend to be less correlated to the U.S. in comparison to larger developed economies around the world.
Creating a Synthetic, Bond-Like Portfolio utilizing Equities Approach
Another asset management strategy that is being discussed more today is creating a synthetic, bond-like portfolio utilizing equities, alternative investments, and certain hedging strategies in conjunction with one another. The idea is to limit portfolio extremes, while providing returns and income levels similar to what core bonds have traditionally offered. These synthetic bond-like strategies consist of some form of absolute return, market neutral, long/short equity, and delta neutral strategies. There is a lot of variation in this particular strategy, but usually entail some coordinated long and short positions that aim to limit market extremes on both ends of the bell curve. Ultimately, the aim is to generate bond-like returns without having to deal with interest rate risk (rising interest rates).
If you would like to learn more about any of these investment strategies and how they could potentially benefit your situation, please contact me directly at (805) 558-8497 or at firstname.lastname@example.org. A disciplined approach to wealth management is critical to pursing financial independence. Financial science identifies the sources of investment returns. I can provide the tools and experience to help you work towards your goals.
Stock investing involves risk including loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
No strategy assures success or protects against loss.
The bond illustration in this material is a hypothetical example and is not representative of any specific investment.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
Treasury bonds are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.