The Federal Reserve raised the fed funds rate a quarter point in September, for the third time in 2018, and signaled one more hike in 2018, as policy makers expressed confidence in the United States economy. Officials continue to project three additional increases in 2019. Rising rates combined with historically tight credit spreads are causing concern among fixed income investors. A prolonged campaign of rate hikes can be a short term drag on fixed income investments, as rising rates mean lower bond prices. Active fixed income investors, however, need not forsake their bond portfolios altogether in light of the rising rate environment. Bonds serve as a stabilizing factor in a portfolio, offsetting the inherent volatility of stocks, and offering the benefits of diversification, capital preservation and income. It is important, though, for investors to use this time to review their fixed income allocations and be thoughtful about fixed income portfolio positioning.
Rising rates can be beneficial over the long term
Interest rate risk is the threat that rising rates will push down the prices of existing bonds. As interest rates rise, bond prices fall and vice versa. The logic is that as interest rates increase, investors are able to realize greater yields by switching to newer issues that reflect the higher rate. The older bonds with the lower coupon rates have to sell for less to attract investors. A bond’s total return, however, encompasses both changes in price and interest payments. Default risk aside, the cash flows for a fixed rate bond are known in advance. While the price of the bond may change as yields move up and down, the total return of a bond held to maturity will not. A rise in prices carries forward some of the bond’s future return, while a drop in prices pushes some of that return into the future. Neither affects the total return investors earn over the bond’s life.
Figure 1: Total return includes price changes and interest payments
When it is time to reinvest bond proceeds from coupon payments or maturities, however, changes in interest rates do matter. Fund managers are able to reinvest interest payments and principal at higher yields in a rising rate environment. The higher rates enhance fund income returns, and over time, the increased income component of a fund’s total return has the potential to more than offset short-term losses in principal. As long as the rise in rates is gradual, as expected, higher income can offset the price declines for older bonds. According to Schwab, since 1976, more than 90% of the total return for a broadly diversified portfolio of US investment grade bonds (represented by the Bloomberg Barclays US Aggregate Bond Index) has come from income payments rather than a change in price.1 Patient investors that hold their fixed income allocation can eventually reap the reward of higher coupon payments. Investors who disregard interest income and consider only price movements are missing half the picture.
Figure 2: Income cushion has played a key role in fixed income total return over time
The bond market uses a measure known as duration to estimate how sensitive a particular bond’s price is to interest rate movements. Duration provides the approximate change in price that any given bond will experience in the event of a 100 basis point (one percentage point) change in interest rates. For example, suppose that interest rates fall by 1%, causing yields on every bond in the market to fall by the same amount. In that event, the price of a bond with a duration of two years will rise 2%. Conversely, a 1% increase in rates will mean an expected 2% decline in the value of a bond with a two year duration. The higher a bond’s duration, in general, the more its price will fall as interest rates rise. For example, a bond with a one year duration would lose only 1% in value if rates were to rise by 1%. A bond with a duration of ten years, though, would lose 10% if rates were to rise by that same 1%.
Figure 3: Bonds with longer durations experience greater price changes
The weighted average duration can also be calculated for an entire bond portfolio, based on the durations of the individual bonds in the portfolio. Duration can be used as an initial step to assess the impact a rise in rates will have on a bond portfolio. The amount of time it will take for a bond fund to recover from a drop in price depends on many factors, including the terms of the bonds in the fund and the pace at which interest rates rise. A bond fund’s duration, which represents a period of time, can be used as an initial step to assess when a fund will break even. Short-term funds generally have shorter durations, meaning they are less sensitive to fluctuating interest rates. It will take longer, however, for intermediate- and long-term funds (with longer durations) to benefit from higher coupons. As noted above, though, it is important to have a long term view. Assuming bond fund distributions are reinvested, and the investment is held over the longer term, income payments can be more significant than the price of a bond fund in determining returns over time.1
Duration can be a useful tool for managing interest rate risk. The average duration of a portfolio can be adjusted as a manager’s interest rate outlook changes. If the expectation is that interest rates will increase, the portfolio’s average duration can be shortened (by adjusting the holdings in the portfolio), moving it closer to zero, to lessen the negative effect on prices. Some fund managers have looked to tactically manage duration exposure as a way of protecting themselves against potential higher market interest rates. Managers have shortened duration, or even gone negative duration. In order to add value through this strategy, however, management must consistently predict the level and direction of interest rates. As these factors are not easy to predict, managers can also look to diversification of asset classes as potential protection from higher rates.
Not all fixed income is created equal
The fixed income market consists of many different types of bonds. Interest rate sensitivity can differ substantially across asset classes based on duration, credit quality and type of security. Broadly, higher quality sectors (such as US government bonds) and longer duration bonds have tended to be the most vulnerable to interest rate volatility, while lower duration and more credit sensitive bonds have historically fared better in rising rate periods. When Treasury rates rise, indicating improving economic conditions, credit spreads should tighten amid an increased appetite for risk assets. The spread compression provides a cushion and potential offset to the price deterioration that occurs when rates rise.
According to Nuveen LLC, between January 2009 and March 2017, there were seven periods in which the 10-year Treasury yield rose by 60 basis points or more. During those periods, total returns for fixed income markets differed greatly, illustrating the benefit of diversification. Figure 4 shows the average of total returns over all seven periods ranked by sector. On average, during periods when Treasury yields were rising, longer maturity, higher quality sectors underperformed, while shorter term, lower quality and securitized sectors outperformed. Returns between sectors vary substantially, with a noteworthy differential of 27.19% between the highest and lowest average returns.2
Figure 4: Average of total returns over seven periods of rising rates (2009-2017) ranked from highest to lowest within categories2
Bond strategies for a rising rate environment
Timing any market is difficult and timing the direction of interest rate movements is next to impossible for most investors. As we have seen, over time a portfolio well diversified across a mix of bond classes and a wide array of maturity dates stands the best chance of outperforming across a full range of interest rate scenarios. Investors that are considering their fixed income investments in light of this low yield, rising rate environment, but would not like to opportunistically time these allocation decisions, can look to actively managed bond fund managers that have the flexibility and skill to manage duration and invest in fixed income asset classes outside of the traditional Barclays US Aggregate benchmark. Active fund managers have a variety of tools at their disposal to position a portfolio in a rising rate environment. A few broad strategies which may prove effective in offsetting some of the negative effects of rising interest rates on bond prices include duration management, asset class selection, global investing and alternative investments.
- Systematically lower duration
Short term bond funds are a good starting point for investors fearful of interest rate risk. Short duration bonds are generally less sensitive to interest rates and offer the ability to reinvest in comparatively shorter periods. In a rising rate environment, short duration bonds may outperform longer duration options. Overall, staying on the shorter end of the maturity schedule can help bond investors avoid negative bond returns, and provide a pick-up in yield during a period of rising rates. There are a few considerations with respect to this asset class, however. First, many bond investors concerned about the impact of rising rates have been looking to passive short term bond funds. According to PIMCO, though, “passive short duration strategies have exposure to the segment of the bond market that is historically the most affected when the Federal Reserve raises interest rates,” with no flexibility to change their exposure (which is heavily weighted to US government bonds) or lessen the impact of a hiking cycle. Rather than taking exposure to the entire short end of the Treasury yield curve, actively managed funds may provide better protection in a rising interest rate environment. Actively managed funds have the flexibility to invest in a wide variety of strategies and securities to manage interest rate risk, whereas passively managed strategies may be more susceptible to interest rate moves.3 A second caveat is while short duration strategies may be appealing in this environment, there are many differences among the short duration asset class. Short duration funds range from relatively conservative to aggressive, and while these funds may have lower relative interest rate risk, they can have other types of risk depending on the securities they hold in their portfolios. It is important to understand that short term doesn’t necessarily mean low risk; and while many of these funds invest in high quality corporate bonds or mortgage backed securities, some managers will invest in lower quality securities in an effort to boost yields. Given some of the nuances of the sector, an actively managed intermediate term bond fund which has broader latitude to adjust interest rate exposure (and offers potentially higher yields) can also be a solid holding in a rising rate environment for investors who would not like to navigate the short duration landscape.
- Tilt the portfolio to credit such as high yield
Adding credit can help diversify the sources of return in a portfolio. It may also increase the yield, providing a cushion against the price impact of interest rate rises. The credit allocation can take various forms, such as investment grade, high yield or emerging markets, depending on risk and return targets. High yield bonds offer the potential for higher yield, lower volatility and less exposure to interest rate risk than more traditional fixed income investments in this low yield, rising rate environment. High yield bonds have historically outperformed other fixed income alternatives in rising rate environments for a variety of reasons. First, high yield bonds are more correlated with economic growth than interest rates. Credit spreads should narrow in an economic recovery as business conditions improve. This spread compression provides a cushion and potential offset to the price deterioration that occurs when rates rise. Moreover, the income pick up from high yield debt is attractive in a low yield, low growth environment like the current scenario. Lastly, high yield bonds benefit from less price sensitivity to interest rate movements given their moderate duration, offering better protection from interest rate risk in the event the economy begins to grow faster. It is important to note, however, that moving into high yield debt means assuming additional credit risk. And, high yield investors today need to consider valuations. Yield hungry investors have piled into the asset class in recent years, leading to extremely tight spreads. With spreads at these levels, investors may not be getting compensated for the risks they are assuming. As the US economy seems to be on solid footing at present, investors have become complacent about the risks, but the sector may struggle if the economy starts to show signs of weakness. While high yield bonds should be considered for a well diversified fixed income portfolio, especially given their resilience to rising rates, the sector carries its own set of unique risks.
- Go Global
Diversifying internationally may also help protect a portfolio from tighter US monetary policy. Although economic growth is improving globally, it is likely that monetary policy divergence between the US and other countries will continue for the near future. More generally, economic cycles are not always in sync on a global basis, and foreign bonds tend to move based on the respective country’s interest rate cycle. Many international fixed income indices have a low, or even negative, correlation with movements in US rates. While many traditional strategies for mitigating the effects of rising rates substitute one risk (interest rate risk) for another risk (credit risk), another way to diversify may be to consider increasing global exposure to developed nations that are currently offering more accommodative environments for bondholders.
- Consider floating rate debt
During periods of rising rates, floating rate loans have outperformed rate sensitive fixed income sectors. Floating rate loans are less sensitive to rising Treasury yields because their coupons adjust to changes in prevailing rates. When rates are rising, investors in floating rate loans generally earn higher income and experience smaller price declines. Their coupons reset every 30-, 60- or 90 days. These regular coupon adjustments shorten the security’s duration, thereby reducing its price sensitivity to rate changes. Moreover, unlike many other short duration instruments, the yields on floating rate notes tend to be high. These higher yields, however, can be commensurate with relatively higher credit risk. Floating rate loans can serve as a source of financing for companies that have below investment grade credit ratings. As such, the risk profile for floating rate loans can be more similar to risk assets such as high yield bonds. A second option is inflation protected bonds, also known as Treasury Inflation Protected Securities (TIPS). These government bonds, whose value rises with inflation, can be a way to achieve a term premium while also hedging against inflation risk. TIPS can do well just before and during inflationary environments, which often coincide with rising rates and growing economies. The use of inflation linked securities can be a solid tool in a rising interest rate environment, as the capital will adjust upwards as inflation rises. That being said, TIPS securities do have significant duration embedded within them, which can negatively impact the asset class as rates rise.
- Keep calm and carry on
Despite investors’ concerns about owning bonds in a rising rate environment, it is important to remember that bonds play a key role in a diversified investment portfolio. Active fixed income investors should not abandon their bond portfolios in light of the rising rate environment. Fixed income helps diversify a portfolio and serves as a potential ballast against volatility in the equity markets. Figure 5 shows that during seven negative calendar years for stocks that occurred since 1977, bonds have enjoyed positive returns.
Figure 5: Bonds have historically had positive returns when stocks have been down
Moreover, a long term horizon and a total return perspective may be all that is required for some investors. Interest income can contribute a majority of fixed income’s total return over time. An increase in income in a rising rate environment has the potential to offset a short term drop in price. Investors who maintain a longer term focus and resist the impulse to react to short term volatility are more likely to benefit from the positive returns of fixed income assets over time. Of course, timing matters, and not all investors can wait for the long term. As such, duration and diversification of the varied fixed income asset classes are key considerations. Selectively shortening duration or moving toward sectors that have proven effective shelters against the storm of higher interest rates can be sensible moves in light of the current economic environment.
Given the nuances of the bond market, and the rising rate environment we find ourselves in, making allocation decisions amongst bond funds dedicated to specific asset classes can be difficult. Investors don’t want to shorten up duration too much and give up yield, or chase yield by allocating too much to riskier asset classes. For investors who do not want to make these investment decisions alone, we recommend choosing a core plus bond fund strategy that has the flexibility to invest across maturities and sectors and can invest their fixed income allocation in a more intelligent way by looking at all aspects of the bond market.
 Charles Schwab, “Should you Hold Bonds or Bond Funds When Interest Rates Rise,” October 2017.
 Nuveen, “Positioning Bond Portfolios for Rising Interest Rates,” December 1, 2017.