Trusts & Estates

Transitioning To A Rising Rate Environment

In the five years since the Credit Crisis and Housing Bubble, the United States economy has been marred with negative or substandard economic growth.

How We Got Here

Job creation and economic activity have been best described as anemic, resulting in unprecedented monetary policies initiated by the U.S. Federal Reserve and the world’s largest central banks. These policies have been titled “quantitative easing” and have succeeded in reducing interest rates to historically low levels.

Since 2008, markets have watched Chairman of the Federal Reserve Ben Bernanke’s every move as the Federal Reserve instituted various forms of quantitative easing in hopes of stimulating economic growth. Quantitative easing is designed to increase the money supply by replacing Treasuries and other government agency securities with printed currency, thus providing financial institutions with capital in an effort to promote lending and liquidity. This type of quantitative easing also lowers interest rates by artificially subsidizing demand for bonds thereby decreasing market borrowing rates. In theory, these lower interest rates will motivate different types of common borrowing, such as refinancing, car purchases, home buying, etc.

In the first eight months of 2013, we saw interest rates on the 10-year Treasury note slowly rise as the markets expected the Federal Reserve to begin reducing its bond-buying program. Market speculation about the timing of the tapering of quantitative easing led to periods of increased volatility. However, on September 18, Bernanke announced that the Federal Reserve would not slow the pace of its bond purchases and that quantitative easing would remain in effect until unemployment and the economy showed additional improvement. Rates then quickly retreated to 2.5 percent in response.

Nevertheless, with more economic data reports trending positive, rates have again begun to slowly ascend higher as the markets once again begin to embrace the eventual tapering of the Federal Reserve’s bond-buying program. Even with what seems to be a gradual increase from say 2.5 percent to 4 percent (where many economists expect the 10-year Treasury note to rise), bond portfolios could see a drastic decline in principal value if not properly diversified.

The Federal Funds rate (an overnight lending rate for depository institutions that serves as a benchmark rate that generally drives the level of all other interest rates) is currently between 0 percent and 0.25 percent, a historically low level. Despite the inevitable tapering of quantitative easing, short-term interest rates are anchored by the Federal Reserve’s current policy initiatives. Since rates are still low, now may be an ideal time for investors to re-evaluate the role fixed income will serve in their portfolio and explore strategies to take advantage of the transition to a rising rate environment.

Strategies To Position Your Portfolio

An effective strategy could be to allocate the majority of a fixed income portfolio to bonds with a shorter duration by investing towards the short end of the yield curve. In the current low-rate environment, shorter-term maturity bonds that have lower yields but less price sensitivity to changes in interest rates can provide stability in a portfolio. When the Federal Reserve begins its tapering of quantitative easing and interest rates begin to rise, those investors with longer-duration fixed income positions could see their bond values deteriorate, as bond prices move inversely with interest rates. Investing in fixed income securities with maturities of less than five years will protect against rising interest rates as shorter-term bonds are less sensitive to movements in interest rates. In addition, as rates begin to increase, these shorter-term bonds will mature or can be sold to reinvest in newer, higher-coupon bonds.

Since volatility is likely to remain in the markets for the foreseeable future, floating-rate debt securities can be used to hedge against some of the interest rate risk. Because the interest rate on these securities is adjusted on a 30, 60 or 90-day interval and is determined by a floating reference rate, usually LIBOR (London Interbank Offering Rate) or the Federal Funds rate plus an additional spread based on the borrower’s credit, their yields will automatically remain aligned with market rates.

Higher-yield bonds, with their higher coupon rates and interest payments (to compensate investors for the increased risk) can help to shield investors from lower bond prices due to rising rates. Rising interest rates generally occur during an improving economy, and since the Federal Reserve has indicated that interest rates would remain at current levels until the economy improves, we should anticipate that any economic improvement would lead to better performance of these bonds since improved credit risk should support their prices. However, as we saw in 2008, investors interested in this asset class must pay particular attention, since a decline in credit markets could lead to significant losses, regardless of the higher stated interest rates.

The use of proficient separate account managers as opposed to accessing fixed income markets through mutual funds can provide an additional benefit in uncertain markets. When markets are in turmoil, mutual funds may be forced to sell their highest-quality, most liquid securities to meet redemption requests, resulting in poor execution. By using separately managed accounts, investors will not suffer the effects of someone else's redemption requests. Furthermore, the potential credit risk as well as the re-investment risk can be mitigated. Barring a default or call, bonds held in a separate account can be held to maturity, ensuring the principal value for the investor.

In conclusion, some of the strategies to consider implementing in one’s fixed income portfolio in times like the present include shortening duration, yield curve positioning, an emphasis on higher-yield bonds and utilizing separate account managers. Risk and volatility are as prominent in fixed income as they have ever been, but these approaches could provide diversification benefits and increased yield to portfolios in this challenging environment. A careful review of your specific goals matched with the objective advice of a trusted advisor should help create a more appropriate portfolio suited for your specific objectives.

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