If there’s one thing the financial community can agree on as the year 2014 approaches it’s that interest rates will rise. When that happens, bonds and other fixed-income instruments will likely come under selling pressure – prices of bonds, held individually and in bond funds, are expected to fall.
Even the bonds in Apple’s vaunted $17 billion issuance in April, backed by some $145 billion in cash, will come under the gravity of rising rates. What the community disagrees on, of course, is how to navigate the coming change in the investment landscape.
In terms of portfolio management I think the course is clear. Bonds will continue to play an important part in helping to diversify risk and reduce overall portfolio volatility.
First, in order to increase the probability of success, investors should reduce interest rate and duration risk by swapping longer-term bonds for shorter-term bonds. By selling longer-dated bonds and investing the proceeds into shorter-term bonds, investors are able to reduce interest rate and duration risk without altering their overall asset allocation mix.
Second, investors should examine the potential alternatives to bonds, particularly the hybrids. Here are three increasingly popular alternatives that – while worth considering – have their own shortcomings and risks as well.
Floating Rate Securities: Floating rate securities are similar to bonds in the sense that they offer a specific maturity date and have a ‘par’ value. However, unlike traditional bonds that offer a fixed coupon, these instruments periodically reset or adjust their interest rate based on a predetermined base rate, most commonly the Fed Funds rate, LIBOR (London Interbank Offer Rate), or CMT (Constant Maturity Treasury rate).
As a result of their ability to reset their coupon, Floating Rate Securities offer some protection against interest rate risk when rates rise. However, if rates drop, the coupon is lowered as well. Moreover, Floating Rate Securities do not insulate investors against duration risk.
Furthermore, since Floating Rate Securities are most often issued by corporation, typically with lower credit ratings, Floating Rate Securities are also subject to credit risk. One example of such a fund is the PowerShares Senior Loan Portfolio (BKLN).
Step-up Bonds: Step-up Bonds are similar to Floating Rate Securities in that the coupon, or interest payment of the bond is reset and “steps up” based on a pre-determined schedule until either maturity or until it is called away. Accordingly, in periods of rising interest rates, these bonds offer some protection against interest rate risk.
However, most of these bonds are callable, meaning that the issuer reserves the right to take the bond back on specified dates – something that is sure to happen if interest rates rise too much. Moreover, Step-up Bonds typically start with a coupon that is lower than traditional bonds with similar maturities pay. Lastly, investors are still subject to the credit risk associated with the issuer.
An example of a set-up bond fund is the PowerShares 1-30 Laddered Treasury Portfolio (PLW).
Treasury Inflation Protected Securities: TIPS as they are usually called, are Treasury Bonds designed to help investors maintain purchasing power by increasing the value of the bond during inflationary periods. While the interest payments of TIPS remains steady, the principal of the bond is adjusted semi-annually based on the Consumer Price Index.
These instruments can be very valuable to investors during prolonged periods of elevated inflation. Since the principal and payments are guaranteed by the U.S. Treasury, these bonds are very safe. You can by TIPS directly from the U.S. Treasury or through a bank, broker or dealer.
However, investors should be aware that there is a risk of underperformance. Furthermore, as is currently the case, TIPS offer protection against inflation, not against rising interest rates. In other words, while there is little credit risk, interest rate risk and duration risk should be considered, with the understanding that interest rates may rise in the absence of inflation. Read that last sentence again: The one thing everyone agrees on, interest rates rising (tied to the end of quantitative easing), may be the one thing that doesn’t happen due to another phenomenon entirely (namely, inflation).
The market, for all its collective wisdom, isn’t always right so always take prudent actions and construct a balanced portfolio that can weather moves in any direction.