INSIGHTS

On July 25, 2013

Investing In Bonds When Rates Are Rising

Successful bond investing is rarely easy but certain interest rate environments can make bond investing look particularly difficult. A sharply rising interest rate environment is one of those difficult investment scenarios, one that may cause some investors to shy away from bond investing altogether. We suggest it is important to remember, particularly in these difficult environments, that objectives usually associated with bond investing still have to be met. Whether it’s the need for reliable after-tax income, relative capital preservation, or overall safety, these needs don’t get to take a day off just because market conditions become unfavorable.

How can investors “stay in the bond game” during these difficult rising rate environments? Here are some suggestions:

• Be aware of the duration of your bonds and of your portfolio as a whole. Duration is expressed in years but its most valuable function is to indicate a reasonable expectation of potential volatility should interest rates rise (or fall). A portfolio with a duration of 4 years is expected to decline in principal value by 4% if interest rates rise 100 basis points (one percent).

• Consider shortening the duration of your bond portfolio. Other things being equal, a portfolio with a shorter duration is expected to fluctuate less when rates rise than a portfolio with a longer duration.

• Duration can be shortened by reducing the final maturity of bonds you purchase or hold in your portfolio. It can also be reduced by buying or swapping into bonds with above average coupons. The increased cash flow provided by above average coupons delivers a portion of the return back to investor more quickly, thus reducing duration and tempering expected volatility.

• Investors can increase the portion of their portfolio that contains relatively defensive bond structures to fight potential downside volatility. Bonds with above average coupons that also have call features, sinking funds, or puts often exhibit defensive characteristics in rising rate environments. These kinds of bonds can’t reverse the laws of bond mathematics but they can help dull the impact of negative volatility through above average cash flow and potentially shorter time to principal payback.

• Investors can be more deliberate in the pace at which they invest cash earmarked for bonds in a rising rate environment. We do not suggest large swings back and forth between sizable cash positions and being fully invested. Unless an investor can claim to be an exquisite timer, we believe the likely volatility of such an approach is not what most bond investors desire for their bond allocations.

• Keep your eyes on the prize. The original yield to maturity or to call is something an investor continues to earn regardless of where interest rates go as long as the bond is not sold and the issuer is creditworthy enough to pay off its bonds at maturity or call date. A total return measurement is simply a snapshot of what happened to interim bond values (and the coupon income earned) for a particular time period. It does not alter that prize of bond investing: original yield to maturity or call.

• When rates are rising, investors’ focus on potentially negative total returns often makes them forget about the more attractive yields that can be captured. A well-designed maturity schedule of bonds coming due at regular intervals can help investors capture these higher yields. Investors do not have to rely solely on that schedule of bond maturities, however, to dictate reinvestment opportunities. They can also improve the portfolio by performing appropriate bond swaps to capture higher yields.

A sharply rising interest rate environment is not pleasant for bond investors to go through. It can prompt such quick reactions as, “Bonds are getting killed today. Why should I bother?” To that, we feel compelled to ask, “Which bonds are you talking about?” Our question points out the reality of a wide variety of bond sub classes in which to invest as well as countless maturity dates, coupon sizes, bond features, and credit quality levels. The broad statement, “Bonds are getting killed today”, is perhaps as meaningful as saying, “The weather in the United States wasn’t good today”. Of course, it all depends on where you are.

The general judgment of many market observers is that interest rates will rise from current levels over the next few years. Judgments on the direction of interest rates can always be debated but it is unusual for interest rates to move in a straight unstoppable line upward. Markets naturally tend to back and fill, to digest sharp movements, to effectively debate the speed of that rate rise every step of the way. We believe bonds can still play a role in a balanced investment program even in a rising rate environment. Knowing what you own in the bond universe from the perspective of asset class, maturities, coupons, bond features, duration, and credit is an essential tool for bond investors, particularly in these challenging markets. It could make the difference between sticking with an asset class that can still perform important investment tasks and unwisely abandoning it altogether.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Municipal Disclosures webpage. For additional risk information see the Blog and Commentary Disclosures website. For additional commentary or financial resources, please visit www.aamlive.com