Rising Rate Strategies

In an earlier discussion on preparing portfolios for rising rates, we sought to illustrate the value of blending rising rate strategies to target a specific yield and duration profile in response to changes in Federal Reserve (Fed) policy. However, over the last 10 months, interest rates have actually fallen as the Fed has reduced the pace of its asset purchases. With “tapering” expected to be completed on October 29, we believe that this approach to risk management may be more relevant than ever as rates remain at depressed levels. In the remainder of this piece, we seek to highlight the total return profiles of these approaches since the start of the Fed’s shift in policy.

Over the last 10 months, nominal interest rates have fallen and credit spreads have generally widened. With hindsight, we know that hedging interest rate risk cost investors performance. Additionally, even though high-yield bonds generated positive returns, risky debt underperformed investment grade credit by nearly 2%. However, we believe we can learn a great deal about portfolio construction from this experience:
1) For most bond investors, the greatest determinant of a portfolio’s total return is the starting yield level. As shown in the table, over this period, the primary driver of returns was the amount of interest rate risk investors had in their portfolios. Unless investors believe that the risk of deflation is poised to increase, we continue to believe that hedging interest rate risk is a prudent course of action.
2) With rates at some of the lowest levels since mid-2013, we continue to believe that the risk of higher rates far outweighs the risk of lower rates.
3) Negative duration strategies and blends underperformed as long-term interest rates fell more than short-term rates. Given that credit spreads also widened over this period, a more opportunistic trade may be to increase exposure to negative duration, high-yield strategies as a way to address rate and credit spread normalization.
While the ultimate evolution of the path of U.S. interest rates remains uncertain, we believe these new strategies for risk management give investors a powerful tool kit for refining their fixed income exposure. Even though rates have fallen over this period, the blended approaches shown above resulted in positive total returns for all but the most aggressive approach. In our view, the ability for investors to maintain traditional bond exposures while reducing interest rate risk can add value once rates begin to normalize.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Non-investment-grade debt securities (also known as high-yield or “junk” bonds) have lower credit ratings and involve a greater risk to principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The duration Funds seek to mitigate interest rate risk by taking short positions in U.S. Treasuries, but there is no guarantee this will be achieved. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions.

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