Focus is shifting more and more towards this question, so education on what affects rates and what can be done to combat their eventual increase is of much importance.
Joseph P. Okaly, the Assistant Portfolio Manager at Buy/Hold Plus, addresses this question, so follow on below to read an article overview or click to read the full Rising Interest Rates: How are you prepared? article.
Part 1: What can be done to combat rising rates?
Conventional thinking often begins and ends with when rates rise, bonds go down in value, with those of longer durations (more years left) affected the most. This results in the most common combative technique, and the one that receives the most attention, of buying shorter term bonds. However, while certainly an important component, shortening duration is not by any means the only strategy in combating rising rates.
It is important to note that the common term of “rising rates” generally boils down to the fear of increasing U.S. Treasury rates – one category of bonds. Clearly, an increase in U.S. Treasury rates will adversely affect all fixed income sectors. However, there is no “pure” correlation between the U.S. Treasuries and other fixed income sectors. In other words, rising rates do not equate to a common loss across all debt securities.
The type of debt securities also affects the reaction to rate changes. Bank Loans for example have a variable or floating rate usually with a lower credit quality. This is completely separate than TIPS which adjust principal for inflation, but have a core tightly associated with government securities. While a large variety of options can provide confusion, it can also provide opportunity in balancing the credit quality, interest, inflation, and extension risks inherent in the bond market.
Part 2: How our bond portfolio is positioned
Our approach is a pre-emptive one, positioning our portfolio to better withstand a rise in interest rates, whenever that does happen to occur. While no one seems to think this will happen tomorrow, when it does happen the popular belief is that it will be quick. The Wall Street Journal’s Matt Wirz recently wrote about just this, citing the changing shift among large bond funds such as BlackRock Inc., TCW Group Inc., and Pacific Investment Management Co.
“Rather than trying to guess exactly when that moment will happen, they are pre-emptively making investments that will pay off when it does. The moves include buying debt with floating interest rates that rise as overall rates climb, as well as interest-rate swaps and inflation-protected bonds that will also increase in value.” – Matt Wirz, Wall Street Journal, March 2013
In an effort to position our clients favorably for this inevitable interest rate rise, our bond portfolios have drastically scaled back their U.S. Government holdings, increased Global and General Intermediate Term Bonds, and added a new asset class in Emerging Market Debt.
Part 3: Case study for previous rising rate periods
While every period of rising interest rates acts uniquely depending on the contributing circumstances, and past history is no indication of future results, it can be interesting to see how funds have navigated previous rising rate periods.
As Figure 3 illustrates by examining the last number of recent rising rate periods, there are still possibilities for bond accumulations despite an environment of rising rates. Global and Emerging Market Bonds illustrate this well during the last period of consistent increases to the Federal Funds Rate, as our portfolio’s global bond holding outperformed the Barclays Aggregate by over 13% during that two year time period of rising rates.
No one knows when rates will increase, only that they will increase at some point in time. However, with a vast amount of fixed income asset classes and security types, rising Treasury rates certainly do not equate to a common loss across the board. Based on current fund allocations and their past successful navigation of rising rate environments, we feel very favorably about our positioning and security selections in the bond market for the uncertain interest rate environment to come.