The strategy of adding bonds to the portfolio has long been a standard tool for mitigating equity market risk to some degree. This has remained true during the post-financial crisis era, but with today’s low interest rate environment, and the Fed now signaling that a Federal Funds target rate increase is highly likely before the end of 2015, advisors need to recognize that a “set-it-and-forget-it” attitude toward the fixed-income portion of an investor’s portfolio may yield different results than what has been experienced in the past.
Interest rates have remained historically low over the past several years. But with recent improvement in employment levels, inflation approaching the Federal Reserve’s 2% target, and sustained strength in equity markets, much focus has been placed on a potential for an uptick in interest rates. Advisors should know that any expected increase in rates will bring added volatility to all portfolios, including those with a bias toward fixed income.
Managing a portfolio’s interest rate risk – with a plan that provides the risk management and potential returns participants require – is more important than ever. With the prospect of rising rates, forward-thinking advisors should address the nuances of fixed-income investing in new ways.
The prolonged period of declining interest rates over the last 30 years has contributed to overall stability in fixed income portfolios. This overall trend has created a false sense of security for some advisors who may not have focused on certain rate fluctuations that have materialized. Despite the long-term decline in rates, periodic, unsustained rate spikes have occurred. This happened during 2013, when the 10-year Treasury bond rose from 1.76% at the start of the year to 3.03% at the end of the year, with the Barclays U.S. Aggregate Bond Index returning -2.02% overall. While it has generally been a declining interest rate environment during the past 20 years, we have observed eight instances when the 10-year U.S. Treasury Bond rose by 1.25% or more from a trough to peak time period and the negative impact on portfolio performance that may occur in a rising interest rate environment.
In managing interest rate risk, it is important to understand that a rising interest rate environment is likely to be associated with increased uncertainty and higher implied volatility in bond yields. A higher degree of implied volatility generally results in larger dispersion of returns across sub-sectors of the fixed income landscape, which we expect to ultimately result in a larger opportunity set for active managers to add value over that which is achieved through passive index-tracking investment strategies.
For this reason, it’s better to use active managers, rather than index-tracking passive investments during periods when we see a higher probability of rising interest rates. Active managers have the ability to adjust the interest rate risk, credit risk and better manage the liquidity risk of a fixed income portfolio than a passive investment vehicle, which can be especially important in a rising interest rate regime.
The fact remains that interest rate risk is the largest source of risk in fixed income portfolios. It is important to maintain a strategic, defensive posture in terms of portfolio duration (sensitivity to interest rate movements), especially when the risk/reward proposition is skewed negatively. This can be achieved in various ways, including tilting the overall portfolio to strategies such as short-term bonds, as well as the inclusion of floating rate securities, whose coupon payments are tied to an underlying reference index, which therefore can benefit from a rising interest rate environment. Incorporating an allocation to non-U.S. fixed income investments, whose performance is less correlated to U.S. interest rates, is also a way to maintain a strategically defensive U.S. interest rate risk posture.
On a more tactical level, the strategy is to enlist managers who can skillfully access a wide opportunity set referred to as “Opportunistic Bond.” The active managers flourishing in this area have two primary characteristics. First, they are not tightly constrained to an underlying benchmark such as the Barclays U.S. Aggregate Bond Index. And second, they are specialists in a particular non-traditional segment of the fixed income market or a particular investment strategy.
Advisors need to look beyond the conventional wisdom that has historically informed fixed income investing during what has been a generally declining interest rate environment for the last 30 years. While there is no silver bullet, a sound plan should include a diversified approach that strategically tilts the portfolio toward reduced interest-rate risk, and employs increased use of active managers, particularly those that specialize in areas of the fixed income market which allow for tactical pursuit of non-traditional opportunities with reduced U.S interest rate sensitivity.
Tony Destro is Vice President and Senior Portfolio Manager for Lockwood Advisors, Inc., an affiliate of Pershing LLC, a BNY Mellon company.