Surviving a rising rate environment

Although the Federal Reserve has sent some mixed signals to the credit markets recently, most don’t question if interest rates will rise, but when. And when the rate hike does come, advisers with clients in or near retirement will need to carefully navigate this new environment to try to take advantage of higher yields while protecting against interest rate and duration risk.

Not so long ago, the formula for success in a fixed-income portfolio seemed pretty simple. Investors, for the most part, could simply buy highly liquid, risk-free U.S. government securities or build a traditional bond portfolio and rely on higher rates aiming to generate positive real returns and current income.

That isn’t the case today. With the Federal Reserve’s overnight federal funds rate near zero, portfolios that are big on bonds — particularly those that have reached for yield by having a longer duration — are the most vulnerable to price risk in a rising rate environment.

BIG IMPACT

Consider the impact a fairly modest 1% rise in interest rates would have on fixed-income securities. According to our research, a 1% rate rise would likely cut the value of high- yield securities by about 4.11%, while Treasury inflation-protected securities would probably see an 8.03% drop and 30-year Treasury bonds would likely lose approximately 20.6%.

To lessen the potential impact of rising rates on client portfolios, many believe advisers should take a multifaceted approach to building an income portfolio. One critical component is to add a layer of diversification within the fixed-income portion of client portfolios.

If the traditional bond portfolio is a mix of government, corporate and municipal securities with varying maturities, then a diversified income-oriented portfolio could start with adding a floating rate component — up to one-third to one-half of an investor’s fixed income portfolio — to provide what many would consider meaningful diversification. These investments have interest payments that typically “float” or adjust based upon prevailing short-term rates. In a rising rate environment, the security will pay more interest as its yield rises, counterbalancing the fixed-income portion of the portfolio, whose rate does not rise.

GOING WITH THE FLOAT

Although they have been around for some time, floating rate securities are becoming more widely available to advisers and clients. The Treasury, for example, began issuing floating rate notes in January 2014.

Advisers also can select from a variety of floating rate securities, including bank loans and collateralized loan obligations.

Bank loans typically have floating-rate coupons, hold a senior, secured position in a company’s capital structure, and have historically low default rates and high recovery rates. While they are an investment that typically performs well when rates rise, this asset class can serve several portfolio functions through different market conditions and provide investors with the ability to capture current yield.

Investing in CLOs is another way advisers can diversify income portfolios to meet income needs of clients in or nearing retirement. CLOs are essentially a diversified pool of senior secured corporate bank loans that seek to generate consistent current income through various environments. In contrast to the markets for collateralized debt obligations or mortgage-backed securities, which suffered defaults during the financial crisis, CLOs came through with strong credit ratings and very low default rates. As a result, CLOs continue to generate strong interest from existing and new investors. CLO issuers saw a record $28.62 billion of activity in the first quarter of 2015.

High-yield municipal bonds can be another piece of a diversified income-oriented portfolio, as they may offer investors higher rates and potential tax benefits. While investors should use caution, high-yield munis often are under-researched, allowing enterprising investors to take advantage of that inefficiency to find well-priced bonds that have solid risk-return profiles.

While every investment carries risks, diversification among asset classes has proven to be a very effective way to reduce overall portfolio risk. For retirement investors in a rising rate environment, one way to reduce this risk is by creating a truly diversified income-oriented portfolio that moves with markets.

Christopher D. Long is president and co-portfolio manager of Palmer Square, a credit and alternatives focused asset manager that is part of the Montage Investments family of funds.

Related Topics: Retirement Watch