LIDO INSIGHTS | Preparing for Rising Interest Rates
We highlight a few of the broader concepts to consider. Of course, nothing replacing a customized wealth plan.
For the last several years we have been in a low interest rate environment that has forced savers and investors to frantically search for yield in less traditional areas of the fixed income and credit markets. Their search has driven valuations in some sub-asset classes to all-time highs (and spreads to all-time lows). Over this same period, the “talking heads” have been repeatedly sowing fear by declaring a “bond bubble” and the coming of a “great rotation” (out of bonds into equities) without encouraging folks to sit back, take a deep breath and really think about how they should be solving for a rise in interest rates.
We’d like to highlight a few of the broader concepts to consider. Of course, nothing replacing a customized wealth plan.
We are not suggesting that we can time the market, nor do we know exactly when the economy will emerge from intensive care and rates will rise or how far and fast for that matter. However, we do know that it is a mathematical certainty that when interest rates rise, bond prices (or generally any other fixed income security) decline. If investing is mathematically considering probabilities, would you think that over the next several years there is a higher probability interest rates will be higher or lower?
Our concern of how much damage, risk and/or loss of value bond investors will experience is predicated on several factors, notably the speed and intensity of the rise. As such, we should consider several scenarios and build a strategy that addresses various outcomes.
For purposes of this discussion let’s look at some simple math to illustrate the magnitude of the valuation issue we highlighted above. Since the value of fixed income is what we are ultimately talking about and since almost all fixed income securities are based on the “risk-free” rates of U.S Treasury securities let’s take a quick look at the impact of rising rates on the 10-year U.S. Treasury Bond. Taking a very simplified approach to a hypothetical example from the SEC’s Office of Investor Education and Advocacy, a Treasury bond that offers a 3% interest rate would decline in value by 7.5% (Face Value $1,000 down to $925) if prevailing interest rates in the market rose by a mere 1% (100 basis equals 1%) leading to a negative total return over a one-year holding period. The example does make a number of complex assumptions about duration, convexity, and structure which weigh into the calculations as well. Clearly, buying bonds at the current elevated market levels is not “risk-free” and may still subject an investor to losses.
However, despite the ZIRP environment and these lofty valuations there are some straightforward and time-tested strategies that an investor may use to help mitigate the potentially harmful effects of a rising interest rate environment on their portfolio.
Bond laddering can be used to address near-term liquidity needs pursuant to an asset-liability matching approach. A bond ladder is a portfolio of fixed-income securities with short term, intermediate term and longer-term maturities. Each security has a different maturity date. The purpose of structuring the portfolio this way is to help minimize interest-rate risk and in many cases, to provide liquidity to fund one’s current lifestyle or other liability. It does not protect from parallel shifts in any way but may provide protection from butterflies and other asymmetric changes in rates. The bonds’ maturity dates are spaced across several months or years so that as the bonds mature the proceeds can be spent or be reinvested in more bonds. The more liquidity an investor needs, the closer together one’s bond maturities should be. In a rising rate environment, the ladder eliminates the need to time the markets and mitigates interest rate risk by allowing maturing bonds to be reinvested in higher yielding bonds. Investors can combine a bond ladder with some of the following approaches to further hedge interest rate risk and create a thoughtful fixed income portfolio to address additional liquidity needs and growth objectives.
Consider duration. Duration measures the sensitivity of the price of a fixed-income investment to the change in interest rates. For example, the price of a bond with a duration of 7.5 years will decline by approximately 7.5% for every 1% increase in rates. Conversely, the price of that same bond will increase by approximately 7.5% for every 1% decrease in rates. Consequently, the price of bonds with longer durations is more sensitive to changes in rates. Therefore, in order to reduce interest rate sensitivity and mitigate the effects of rising rates investors may consider reducing the duration of their fixed income holdings.
HIGHER YIELD, LOWER RATED DEBT
Under the right circumstances, investors may also consider taking more credit risk than interest rate risk within their fixed income portfolio. Since fixed income securities are subject to two main risks, credit risk (risk that you will not be paid the cash flows you are expecting, income and principal) and interest rate risk (risk of rising rates), one can skew their investments toward either risk. In a rising rate environment where interest rate risk is arguably of greater concern, investors could possibly shift toward non-investment grade fixed income securities like high yield bonds, emerging market bonds, or floating bank loans (also called leveraged loans). Yields of each type of these securities are generally higher than investment grade fixed income to compensate investors for the greater credit risk inherent in the security. As a result of the higher yields, they typically have shorter durations than the investment grade fixed income securities. Therefore, at times by taking more credit risk one can possibly lower interest rate risk, which is arguably the primary concern in a rising rate environment.
Finally, consider adding alternative income-oriented investments. There is a whole private credit industry that often bypasses typical money-center banks. Private lending pools often with institutional investors command higher yields for alternative debt structures. Although this list is not exhaustive, typical investment options in this category include private real estate investment trusts (REITs), private mezzanine debt, various First Trust Deed asset-backed loans (FTDs), and business development loans. These investments typically are not daily liquid such as a stock or a bond that trades daily. Rather, there is a term for the investment. One of the benefits is the portfolio can act as a portfolio diversifier that is not directly correlated with a liquid market. For example, in the private investment universe a Trust Deed is an asset-backed loan often tied to real estate. If you believe that the value of the asset is worth more than the liability such as the loan, the debit interest may offer a higher yield than a typical corporate bond.
Equity investments are not generally used to supply income due to the volatility inherit in equity investments. That said, if an investor is considering the total return potential of an investment (yield plus growth) over a full business cycle, equity investments are worth digging deeper into. Common stocks can benefit as the economy grows and businesses become more profitable. Focusing on stocks that pay rich and consistent dividends mitigates the equity risk and provides supplemental income to one’s fixed income portfolio.
In short, we believe bonds may play an important part in a well-constructed investment plan and portfolio. We agree with the “talking heads” that bond valuations are stretched and the most likely direction of rates is up at this point in the cycle. However, we are not suggesting that one abandon bonds nor are we suggesting that we should back up the truck and buy indiscriminately. Rather, we believe there are some simple ways to plan for, prepare for and ultimately mitigate the interest rate risk in one’s portfolio without abandoning bonds altogether. Wall Street will surely conjure up structured products to address rising rate risk, but given these common sense oriented approaches, an investor doesn’t have to be subjected to opaque structures, large fees and scare-tactic sales pitches to effectively manage the risk in their portfolio.
i Example as of 2/20/2021– https://www.sec.gov/files/ib_interestraterisk.pdf.
ii In addition to a higher yield to compensate for the higher credit risk, leveraged bank (non-investment grade) loans are typically structured just like the investment grade bank loans and use floating coupon structures that adjust the reference rate (typically LIBOR) as interest rates change.
iii One may ask how to get comfortable by simply trading one risk for another, but in practice rising longer term interest rates indicate that the market believes that inflation may be on the horizon and inflation is typically driven by an improving economy. With an improving economy the likelihood of a default by a fixed income issuer should arguably be declining as their business improves, hence the credit risk that the investor has chosen to take on may actually be declining or beginning to decline.
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