Protecting Portfolios Against Rising Rates: A Holistic Approach

by Peter Essele, CFA, CAIA, CFP, Commonwealth Financial Network

With the Federal Reserve poised to raise interest rates for a third time later this year, you've likely spent a lot of time thinking about the best strategies for protecting portfolios against rising rates.

But have you also spent time assessing interest rate risk? After all, not all bonds are created equal, and you must look beyond the sacred duration measure represented in Morningstar^®.

Here, let's take a deeper dive into one of the basic tenets of portfolio construction: assessing portfolio exposures through a holistic lens rather than viewing them in isolation.

When your clients express concern about the price impact of rising interest rates on their portfolios, they are typically referring to interest rate risk. Often, this risk is measured by a bond's duration. If a bond's duration is measured as 5, for example, then a 100-basis-point (i.e., 1-percent) parallel move higher in rates should theoretically translate into a 5-percent loss for the portfolio, ceteris paribus.

This is true—in theory. But, in reality, this "hard" duration measure is fairly simplistic and doesn't adequately address exposures in a holistic context. It is often a better metric for assessing the price impact on a single security (e.g., a U.S. Treasury bond) than on an entire portfolio. Why? Portfolios often include an array of exposures. When these exposures are combined, they can do a fairly good job of mitigating interest rate risk in the traditional sense.

So, how can you help protect your clients' portfolios from rising interest rates and provide a holistic approach to assessing this risk? Let's consider three exposures that may help you do just that.

Spread-oriented exposure. Allocating a portion of your client's portfolio away from Treasuries and into spread-oriented sectors can potentially reduce interest rate sensitivity. Of course, some would argue that Treasury securities have the strongest interest rate risk. But keep in mind that spread-oriented products (e.g., corporate bonds, mortgages, and high-yield investments) often have many other characteristics that influence how a particular security trades. So, a movement in Treasury rates one way or the other doesn't always translate into a corresponding movement in price based on a stated duration.

In fact, corporate bonds, especially lower-quality names in the high-yield space, have historically exhibited a positive correlation with an increase in rates. Over time, they have also recorded a stronger correlation with equities than have Treasury securities, especially in periods of economic turmoil. When the economy improves and interest rates move higher, many securities tend to get upgraded (e.g., a movement from BBB- to AA-rated), which results in an increase in price.

To illustrate this point, let's consider a mutual fund that holds AAA and BB bonds in an improving economy associated with rate increases.

• There would certainly be pricing pressure on the AAA securities in the portfolio because of interest rate sensitivity and Treasury-like credit quality.
• As fundamentals improve, some names in the BB space would most likely be upgraded.
• Consequently, there would be a mitigating effect in the fund, with some securities seeing pricing pressure and others experiencing upward movements in price.

Global exposure. The use of foreign fixed income securities is another means of protecting portfolios against rising rates. It's unlikely that interest rates around the world would all rise at the same time or affect securities in the same fashion. Markets are becoming more integrated, but a fair amount of segmentation still exists. As a result, correlations among rates in various developed and emerging countries are still somewhat muted.

For example, what if Brazilian yields were to rise due to inflationary pressures at a time when Singapore was entering a recession? Under these circumstances, an income portfolio could experience a decline on the Brazilian position and a corresponding increase from the exposure to Singapore sovereign debt—effectively netting out any price impact from a move in rates.

Equity exposure. When markets experience a rate increase, it's generally in response to inflationary fears and an expanding economy. If the economy expands at a healthy pace, this usually coincides with a movement higher in equities: as earnings growth accelerates, investors become more confident in the environment, and price multiples expand beyond historical levels. So, barring a wildly inflationary environment, equities can represent an attractive asset class in rising rate environments and help offset any losses that may be experienced in fixed income positions within a portfolio.

Also, because of the low correlation between equities and interest rate-sensitive securities, allocating a portion of a portfolio to domestic and international equities that offer attractive yields can accomplish two things:

1. Potentially help preserve the real value of the portfolio
2. Mitigate fixed income pricing pressure in the face of modest inflation and a rise in rates

If you were to aggressively insulate the fixed income portion of a 60/40 portfolio against a rise in rates, you would, in effect, correlate the entire portfolio and remove the so-called risk-off downside protection. This could be potentially disastrous during a credit event similar to that of 2008, when risk assets sold off precipitously.

On the other hand, you could take a holistic approach to assessing the overall interest rate sensitivity of a portfolio by using the various exposures discussed here. By focusing on the forest rather than the trees when making allocation decisions, your clients will have a better view of the big picture.

Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Investors should talk to their financial advisor before making any investing decisions.

Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved.

Special risks are associated with foreign investing, including currency fluctuations, economic instability, and political developments.

The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.

Editor's Note: This post was originally published in September 2015, but we've updated it to bring you more relevant and timely information.

*****             

Commonwealth Financial Network is the nation’s largest privately held independent broker/dealer-RIA. This post originally appeared on Commonwealth Independent Advisor, the firm’s corporate blog.

Copyright © Commonwealth Financial Network