Many pundits predicted that interest rates would rise in 2014, and interest rates actually fell quite a bit. Worries about global growth, geopolitical concerns, and demand from both foreign and institutional investors drove down interest rates. Now predictions that rates will rise in 2015 are again en vogue. Although the prognosis will likely be proven right over time, as investors position their portfolios for a rise in rates, it is important that they ask themselves the Five W’s. They need to ask When, What, Where, Who and Why.
As mentioned above, the first question that many investors may already be asking is “when are rates going to rise?” Recently many investors have found out what seasoned fixed income managers have known for a very long time. Trying to time interest rate movements is extremely difficult. In fact, many bond managers do not even attempt to time interest rate movements and focus strictly on issue and sector selection, trying to avoid defaults while collecting steady coupon payments. This is a long term approach to fixed income investing.
What is really going to happen? Put another way, how much are rates going to rise and how fast are they going to rise? If rates only go up incrementally over a long period of time, this would be less of a shock to a fixed income portfolio. Existing coupon payments and higher yields on new bond purchases could offset some of the price fluctuations caused by rising rates. How much rates move and how fast rates move is very important. Currently, many forecasters predict that rates will rise gradually over an extended period of time.
To expand on the previous point on how quickly and by how much rates move, where on the yield curve rates rise is also very critical. The Fed is talking about raising the Fed Funds rate which would impact short term interest rates. This may cause short term rates to rise, but the impact to long term rates is not the same. Currently there is demand for longer dated treasuries from foreign investors who like the strong dollar, relative safety and higher interest rates in the United States. These technical factors could cause long-term interest rates to remain low and the rate of increase for longer term interest rates could be much smaller than shorter term interest rate increases. Yield curve positioning is essential as rates move differently for 1, 3, 5, 10 and 30 year bonds. And while we expect long term rates to rise less than short term rates, as duration increases, smaller changes in rates have more of an impact on returns.
Rates in the United States are expected to rise this year, but this is not the case around the world. Interest rates in many emerging market countries and Europe are expected to fall in 2015. Before one invests in these countries’ bonds, however, it should be noted that these countries’ currencies may also be expected to fall versus the dollar, eroding possible gains from falling rates.
Finally, why rates are going up is important. U.S. rates are expected to rise because the economy is improving and growing. Corporate balance sheets are stronger and default rates are expected to remain low. If rates rise because the economy is improving, that can be a good thing. Savers will be compensated with higher rates of interest and retirees living off income may find it easier to generate more yield.
The possibility of interest rates rising does not come with an easy solution. There are many questions that need to be answered. Investors that shun duration all together are losing the benefit of diversification that duration provides against equity markets. As 2008 becomes a distant memory, many forget that high quality bonds were one of the only asset classes in 2008 that was actually positive. When it seemed like all risky asset classes were trading down in unison, bonds provided portfolios with that essential buffer and actually delivered on their ability to protect on the downside. Looking ahead, geopolitical risks remain and volatility is expected to rise. Therefore eliminating duration altogether from a portfolio could be very risky for a conservative investor.
As we know, bond prices will fluctuate with interest rate movements. If yields rise, existing bond prices fall. If yields fall, bonds rise. If bond prices fall due to rates rising, this merely reflects that one can buy a new bond with a higher interest rate. Although there may be fluctuations in the price of a bond, barring any default, the investor will get paid back the principal while collecting coupon payments along the way. If the bond is sold before it matures, it could be sold at a loss, but the proceeds could be reinvested at a higher interest rate (barring any changes to credit spreads and market liquidity). The real issue here may lie in an investor’s time horizon and matching duration to this time horizon. If one needs to withdraw money in the near future that money should come from short duration allocations. Money needed in later years should be matched to a portfolio with the appropriate duration.
Stay diversified and keep some interest rate sensitivity in portfolios. In other words, we don’t recommend a zero duration fixed income portfolio. Duration can protect against equity volatility and is a good insurance against crisis situations. Rates will likely rise at some point, so keeping duration shorter than long term goals may benefit a portfolio as there may be a possibility to reinvest at higher rates in the future. Investing with active managers who can manage this yield curve positioning within a portfolio’s guidelines and manage sector and issue selection in an attempt to minimize defaults could benefit a portfolio. These managers may be able to better navigate the When, What, Where, Who and Why questions. In addition, as markets become dislocated such as has recently occurred in the energy sector, it could present opportunities for these managers. We also favor an overweight to corporate and high yield bonds. Overweighting credit and collecting higher coupons could help buffer a portfolio against rising rates as defaults are expected to remain low for the next couple years.
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Cetera Investment Management LLC provides passive and actively managed portfolios across five traditional risk tolerance profiles to the clients of financial advisors, who are affiliated with its family of broker-dealers and registered investment advisers. Cetera Investment Management is part of Cetera Financial Group, Inc., which includes Cetera Advisors LLC, Cetera Advisor Networks LLC, Cetera Financial Specialists LLC, and Cetera Investment Services LLC.