INSIGHTS

On August 07, 2017

Preparing Portfolios: Four Themes for Higher Rates

By JB Golden, CFA, First Vice President, Portfolio Manager

Concern over central bank policy and low yields, especially in sovereign debt markets, has recently renewed consternation and conversation over the potential that global bond markets are exhibiting characteristics of an asset bubble. Former Federal Reserve Chairman Alan Greenspan recently expressed concern over the potential for volatility in bond markets as central bank policy begins to focus on normalization.¹ There are reasons to be concerned. The FOMC (Federal Open Market Committee) is currently tightening monetary policy in the US with expectations that they will begin to unwind their balance sheet in short order. In addition, global economic conditions look to support higher rates and the potential exists for higher inflation moving forward when and where global growth picks up. For these reasons, we are defensively positioning fixed income portfolios in anticipation of higher rates and the potential for volatility in fixed income markets. We get asked frequently what this process entails and it generally revolves around four general themes.

1. Allocate to High Coupons

There is an old bond market adage that one should: “Buy coupons in the direction the market is headed.” It operates on the simple premise that as rates fall investors benefit from holding longer duration, smaller coupon bonds which tend to appreciate more with falling rates while holding higher coupon, lower duration bonds during periods of rising rates tends to cushion total return while providing higher current cash flows that can potentially be reinvested at prevailing rate levels which would maximize reinvestment return. Weighted average coupons tend to play a large role in returns and the larger the weighted average coupon the better returns have been during periods of rising rates. This should come as no surprise, as income return on a fixed income instrument tends to be the largest source of return over longer time frames. Since weighted average coupon equals income return when looking at annual time frames, one should look at coupon or income return as offsetting price return losses which occur during periods of rising rates. In addition to providing the potential for a total return cushion, higher coupons also tend to be less sensitive to interest rates due to the negative relationship between coupon and duration with duration falling as coupon rates increase, all other things being equal. This negative relationship reflects the fact that higher coupons generate higher levels of current income allowing for faster reinvestment at prevailing rate levels which, in a rising rate environment, reduces sensitivity to interest rates. In structuring portfolios in the current environment, we would look to maximize coupon rates within the context of client risk tolerances as we see more risk to the upside in regards to inflation and interest rates moving forward.

2. Structure a Bond Ladder and Position Duration Defensively

In an environment where rate uncertainty abounds, structuring portfolios in a laddered fashion may reduce overall interest rate sensitivity while positioning portfolios to take advantage of any potential increase in interest rates. Laddering bonds helps reduce interest rate risk through the diversification of maturity exposures. It operates on the same principle as equity diversification or diversifying credit risk. By placing monies at each rung in a laddered structure you are helping to minimize, or smooth, the volatility created by a move up or move down in rates at a specific point on the yield curve. Bond ladders also provide a mechanism to help maximize portfolio income and return especially in the context of a rising rate environment. As rates move up shorter-term positions mature or can be sold with minimal risk to principal allowing for reinvestment at higher rates on the longer end of the ladder. When structuring a bond ladder, we lean on duration as a measure of interest rate sensitivity. Duration approximates the percentage change in price for a 100 basis points (bps) movement in interest rates. For instance, the current 10 Year Treasury (T 2.25% 08/15/27) has a duration of 8.91 years and with a 100 bps increase in interest rates the security should lose approximately 8.91% in value. Longer duration provides the potential for more return but also leads to more price volatility, while shorter duration reduces interest rate risk but provides lower returns and presents the possibility of having to reinvest in a low rate environment. Bond ladders provide a way to take advantage of longer duration return while the inclusion of shorter-term maturities tends to mitigate interest rate risk. We currently favor 10 -12 year bond ladders with higher than market coupons which tends to leave portfolios defensively positioned in the 3.5 to 4 year duration range.

3. Add Inflation Resistant Holdings

With the prospects for higher inflation and higher rates over the next 12-18 months, we see a need to ensure fixed income portfolios include an allocation to inflation resistant assets. You can reduce a portfolio’s sensitivity to higher inflation and, in some cases, position assets to take advantage of an increase in the prevailing level of inflation by looking to assets that tend to be sensitive to inflation. These include TIPS (Treasury Inflation Protected Securities), floating rate fixed income and fixed income tied to inflation indices such as CPI (Consumer Price Index) floaters. One could also consider sector exposure to areas that historically benefit from higher inflation such as basic materials, commodities and financials. Given the recent weakness in both inflation expectations and commodities and basic materials markets, many inflation resistant assets currently trade at depressed levels and we believe should occupy a current allocation in many fixed income portfolios. Inflation is the biggest enemy to bond investors as it reduces the purchasing power of the fixed cash flows associated with most bond holdings. Fixed income investments that have variable cash flows that adjust with inflation such as TIPS and floating rate securities can help to mitigate losses in purchasing power.

4. Allocate with a Preference for Credit Risk over Interest Rate Risk

There are numerous risks that could impact a bond’s total return performance, but the two primary risks most important to fixed income investors are interest rate risk and credit risk. Fixed income holdings are sensitive to these two factors in varying degrees and understanding both is key to constructing diversified fixed income portfolios that are suitable for a given client’s risk tolerance. Interest rate risk is defined as the risk associated with a change in the prevailing interest rate environment. Credit risk is defined as the risk that an issuer will default on its obligation to the investor to pay principal and interest on a timely basis. This brings us to an important observation in regards to performance in the fixed income markets. Credit sensitive fixed income tends to outperform during periods of rising rates where rates move up based on healthy economic conditions. Unlike previous rate increases post-2008, rates look to be supported by improving US corporate earnings, healthy US labor markets, increasing expectations in regards to inflation and expectations for GDP (gross domestic product) growth. Under this scenario, you would generally see falling corporate default rates or the expectation of falling default rates and this has been the case since mid-2016. As economic conditions improve investors demand less compensation for taking on credit risk and credit spreads tend to narrow, minimizing price return losses versus less credit sensitive fixed income. This has also been the case over the past year as credit spreads have narrowed and lower investment grade and high yield holdings have outperformed more interest rate sensitive fixed income such as Treasuries and Agencies. While credit spreads have narrowed considerably over the last 12 months and one cannot expect narrowing to continue unabated, we believe more credit-sensitive holdings are currently supported by the current economic backdrop. In addition, more credit-sensitive holdings tend to carry higher weighted average coupons, also a benefit in both a flat and rising rate environment.

Few bonds are immune to higher inflation and higher interest rates, although steps can be taken to potentially offset some of the effects of negative price returns that come with higher rates. While interest rates in the US have increased over the last 12 months, we are still in a very low range on a historical basis. This leaves investors with historically low levels of compensation for taking on duration or interest rate risk. By employing the four themes above, investors may be able to partially offset or insulate portfolios against higher rates while leaving portfolios positioned to potentially take advantage of higher yields as rates reset.

1. https://www.cnbc.com/2017/08/04/greenspan-bond-bubble-about-to-break-because-of-abnormally-low-interest-rates.html

CRN: 2017-0807-6083 R