Fixed-income investors often associate rising rate environments with falling bond prices. But advisers and clients who prepare themselves might find that certain strategies provide a more competitive total return, according to “Fixed Income Strategies for Rising Rate Environments.”
Several factors have led to the current low interest rate environment, RidgeWorth said. “We expect short rates to be low for quite some time,” said Chad Stephens, managing director at StableRiver Capital Management and portfolio manager of the RidgeWorth U.S. Government Securities Ultra-Short Bond Fund. “While short-term rates and the Fed’s tapering of quantitative easing are not independent of each other, this tapering does not necessarily indicate that the Fed is imminently going to go raise short term rates.”
Bonds continue to offer solid performance potential, RidgeWorth contends. Rising interest rates often worry fixed-income investors, who fear that higher rates will diminish the value of their bonds. But according to Ridgeworth, a look at previous rising rate scenarios may suggest that higher interest rates do not necessarily lead to weak returns for select fixed-income investments.
Investors should consider a targeted approach. Those investors who are aiming to reduce exposure to interest rate risk may be interested in the specific features found in ultra-short bonds and floating rate securities.
Ultra-short bonds and floating rate bank loans can be used to prepare for changing rate environments, the paper suggested. Because of ultra-short bonds’ lower sensitivity to rate changes, these bonds may offer greater price protection than their longer-term equivalents. Floating rate bank loans feature coupons that reset as interest rates change, generally allowing them to hold their value in a changing rate environment.
An allocation to fixed-income securities may be used to reduce risk while providing diversification. However, there are risk factors associated with these securities. Some key risks associated with fixed income investing:
Interest rate risk: The risk that a bond’s value will fluctuate due to changes in interest rates. In general, when interest rates rise, bond prices fall, and vice versa. In a rising rate environment, bondholders may see the value of their holdings decline because higher yielding alternatives may be available in the market.
Credit spread risk: The change of the yield differential between U.S. Treasury and non-U.S. Treasury securities such as corporate bonds. In the years since the financial crisis, credit spreads have narrowed. When interest rates rise, credit spreads usually contract. However, in the current state of low absolute levels of interest rates and credit spreads, there is a risk that credit spreads could expand if interest rates rise quickly as investors favor equities and other asset classes over bonds.
Default risk: The risk of loss from the bond issuer’s inability to repay principal or interest when it is due. An issuer’s default risk is tied to its projected future cash flows, which the issuer will use to repay its debt obligations. Typically, default risk declines in a rising rate environment. As the macroeconomic environment improves, credit fundamentals also tend to improve, lowering the likelihood of issuer default.
Liquidity risk: The risk an investor will be unable to sell a security at the asset’s estimated carried value. Liquidity risk typically applies to higher-risk securities and those for which the market demand is relatively small. In a rising rate environment, liquidity risk may increase among certain securities due to investor preferences for higher yielding bonds or bonds with mark-to-market values that are less sensitive to rising interest rates.
The paper concludes that investors may want to consider shifting the fixed-income portion of their portfolios into professionally managed strategies designed to combat, or even benefit from, rising interest rates.