Interest rates are tenaciously unpredictable. In the US in particular, where we've seen rates hovering near historic lows for several years, the risks associated with investing in a potentially prolonged rising-rate environment have naturally weighed on the minds of investors. In truth, however, there are a number of ways for fixed income investors to diversify their portfolios in order to manage this risk.
Not All Fixed Income Is Created Equal
The fixed income universe is large and diverse—and typically not all sectors react to interest-rate movements in the same way. Generally speaking, higher-quality sectors (such as US government bonds) and longer duration bonds have tended to be the most vulnerable to interest-rate volatility. Alternatively, spread sectors (non-government bonds), and in particular higher-yielding sectors, have tended to exhibit less interest-rate sensitivity which is evident by their lower and, in some cases, negative correlation to US Treasuries.1
Strategies for a Potentially Rising-Rate Environment
Fixed income strategies that have tended to be less interest-rate sensitive include those that focus on credit, limit duration exposure, or are global in nature.
- Credit-Oriented Strategies: Credit quality is an indication of a bond's potential to default. The lower the credit quality, the greater the risk of default and vice versa. Credit quality also tends to influence how sensitive a bond is to interest-rate movements. Higher-quality bonds will typically be more interest-rate sensitive.
Bonds with lower credit quality tend to perform better when the fundamental financial strength of the issuer is improving (which often corresponds to an expanding economy and higher rates), but performance is also likely to suffer when their financial strength deteriorates.
Non-investment grade credit sectors such as high-yield corporate bonds and floating-rate bank loans are two fixed income asset classes that have tended to have negative correlations to Treasuries since their performance is typically tied more to the economy and corporate earnings than interest rates.
- Shorter Duration Strategies: Shorter-duration securities are generally not as sensitive to rate movements and can offer an attractive alternative to longer-duration securities where rising rates typically have a greater effect on price and valuations. In a rising-rate environment, short duration securities or strategies allow investors the opportunity to reinvest principal at progressively higher rates as existing debt matures.
- International and Global Strategies: Individual countries have their own unique interest-rate environments and are typically less impacted by rate changes in the US. By investing in international or global strategies, investors can potentially capitalize on differing business cycles and economic conditions present around the world.
What About Government and Municipal Bonds?
Government Bonds: Where Rates Matter Most
Because government bonds have no credit risk (being backed by the full faith and credit of the US Treasury), the most significant risk associated with these bonds is interest-rate risk. And typically, the longer the maturity of the government bond, the greater the exposure to interest-rate risk.
But Which Interest Rate? Short-term government bonds are primarily affected by the short-term interest-rate changes driven by the Federal Reserve Board (the Fed) adjusting its Federal funds rate. In contrast, 10-year Treasuries and other longer-term bonds are market driven, generally moving in anticipation of inflation expectations and economic growth, driven by demand from buyers of bonds. In the past, for example, during periods of global investor anxiety, there has often been what's termed a "flight to quality," which usually refers to the movement of investment dollars from perceived riskier assets to Treasuries.
Municipal Bonds: Still Quite Sensitive
Municipal bonds rated investment grade or higher tend to carry relatively little credit risk. Though there have been a few high profile bankruptcies in recent years, overall, defaults in the muni world have been quite rare. So, as with government bonds, munis tend to be quite sensitive to interest-rate fluctuations.
It also should be noted that insured muni bonds are the most interest-rate sensitive type of municipal bond. Since their insurance guarantees timely payment of interest and principal, any credit risk is insured away, so interest rates become the primary risk driver.
The Need for Income Is Far More Certain Than the Interest Rate Outlook—All the More Reason to Diversify
