Interest rates are on their way up. In September, the Federal Reserve increased the federal funds rate from 2% to 2.25%, the eighth increase since December 2015. With that said, rates are still low by historical standards, and with an economy that is steadily improving, the Fed is set to increase interest rates several more times in the coming months.
Rising interest rates are something for which fixed-income investors have to prepare. Many fixed-income instruments perform poorly when interest rates rise because securities pegged to a lower rate than what the market currently offers are unattractive to investors. There are various strategies fixed-income investors can deploy to earn profits when interest rates soar. Below are four tactics to consider.
INVESTING IN SHORT-TERM BONDS
When interest rates are trending higher over a long period, shortening the duration of your portfolio can alleviate interest rate risk. Since the prices of bonds have an inverse relationship with interest rates, long-term bonds are more exposed to the risk of a substantial decrease in value due to increasing interest rates. This strategy can help in a few ways.
While short-term bonds may offer lower yield relative to longer-dated securities, short-term bonds are generally less risky to hold until maturity. Since they are less sensitive to severe drops in prices, they are easier to sell even when interest rates do rise. Transitioning to short-term bonds is not without its disadvantages; however, this trade-off is nonetheless worth considering if interest rates continue to rise.
FLOATING RATE BONDS
Floating rate bonds, also known as “floaters”, have a variable rate of interest that resets periodically, based on either the federal funds rate, LIBOR, or a benchmark plus an added ‘spread’. While the yield of the bond will fluctuate as the reference interest rate changes, the spread typically stays the same. Yields can be reset daily, weekly, monthly, or every 3, 6, or 12 months.
Floaters can effectively remove interest rate risk, generally performing better than traditional fixed income securities as interest rates are increasing. The downside is naturally that investors in floating rate securities will risk lower yields when interest rates adjust downward. Additionally, since variable rate bonds will reduce interest rate risk, the initial coupon of a floater is typically lower than that of a fixed-rate note of the same maturity and credit quality.
Considering the current strength of the economy and extended periods of lower than usual interest rates, the markets are showing confidence in a consistently increasing interest rate environment. Floating rate bonds provide a strong investment case during this part of the economic cycle, while additionally providing a hedge against potential inflation.
A bond ladder is an investment strategy whereby an investor purchases bonds with varying maturities. The range of the ladder will depend on an investor’s investment time horizon, with shorter ladders spanning 1-7 years and longer ladders being built across a range of up to 30 years. Maintaining the ladder requires re-investing maturing bonds into new bonds with maturities to maintain the target allocation balance.
This approach can help alleviate the risk inherent in purchasing bonds when interest rates are rising. Purchasing short and medium-term bonds with varying maturities will enable investors to maintain better control over exposure to interest rate risk. Re-investing the proceeds from maturing bonds into newly issued bonds will also provide investors the opportunity to take advantage of the rising interest rate environment. Bond ladders also provide predictable cash flows.
While bond ladders typically require considerable capital, they are a great way to mitigate interest rate risk.
Treasury Inflation Protected Securities, or TIPS, are a type of bond issued by the Treasury that provide protection against inflation. The principal value of TIPS change each month based on movements in the Consumer Price Index, increasing during periods of inflation and decreasing during periods of deflation. Because inflation is generally correlated with rising interest rates, the inflation protection built into TIPS is an advantage over other bonds with no such protection when interest rates rise. While the coupon rate for TIPS is fixed, when the principal value adjusts, investors will receive higher coupon payments. TIPS do have two major drawbacks. First, if the economy goes through a period of deflation, their principal value is reduced. Second, they generally offer lower interest rates relative to conventional bonds. Despite these detractions, TIPS are a reliable investment option to maintain fixed income exposure in your portfolios when interest rates rise.
Of course, no sound investment strategy should be centered solely around the possibility of rising interest rates, but considering certain investment options that can help mitigate interest rate risk is wise, especially given the current investment environment.