Bonds in a Rising Rate Environment

Bonds in a Rising Interest Rate Environment

Investing in bonds is often perceived as boring and vanilla but most individual investors don’t have 100% of their portfolios allocated to stocks. In fact, conventional wisdom for decades has been that as you approach retirement age you should reduce your exposure to stocks and increase your Fixed Income allocation. For the most part, that strategy has been effective. But what will happen to your fixed income investments when interest rates inevitably rise? The answer: It depends.

Like stocks, which are categorized by market capitalization, geographically, by sector, growth vs. value, and in a number of other ways, fixed income investments also come in different “flavors.” There are bonds issued by developed sovereign nations such as U.S. Treasuries or German bunds. There are municipal bonds issued by states and local governments; some backed by the full faith and credit of the municipality and others dependent on revenues from the specific project they are helping fund. There are corporate bonds issued by both domestic and international corporations that range from investment-grade to high-yield (aka junk). There are bonds issued by emerging markets countries such as Turkey or Brazil. There are bonds backed by mortgages, both residential and commercial. There are inflation-protected bonds such as Treasury Inflation-Protected Securities (“TIPS”) and floating rate notes and bank loans.

Each of the categories above has its own unique characteristics and risk profile. Each has varying degrees of interest rate sensitivity and credit risk based on the perceived safety of the issuer, the time till maturity, the coupon, and other factors. As if it wasn’t complex enough already, investors then need to determine whether to utilize mutual Funds, exchange-traded funds (ETFs), or individual bonds in their portfolios.

One strategy to consider as interest rates rise is the use of a bond ladder. A bond ladder is a portfolio of individual bonds (typically corporate bonds or munis) with staggered maturities. For example, if we were allocating a $500K bond portfolio, we might buy 10 to 15 bonds from different issuers, with maturities ranging from years 2020 to 2035. The benefit of this structure is that as the bonds mature, if interest rates have risen, we will have an opportunity to reinvest the proceeds from the maturing bonds at a higher yield than we were receiving previously. A bond ladder can only be created using individual bonds because mutual funds and ETFs are perpetual investment vehicles that never mature.

In recent years, in anticipation of rising interest rates, Asset Managers have developed a number of new products that either simulate Bond Ladders or give portfolio mangers the flexibility to invest across segments of the Fixed Income market (i.e., unconstrained funds). Many of these funds are relatively new and their ability to navigate a rising rate environment is yet to be proven.

Regardless of the strategy you choose, we always remind clients to stay focused on your investment goals. For most investors, that means earning a rate of return that will allow you to meet your retirement goals, purchase that house on the lake, or simply maintain your purchasing power as inflation rises.