Protecting Your Fixed Income Portfolio in a Rising Interest Rate Environment
Posted in: Personal Financial Management
Bond holders, take note: with the economy improving, the Federal Reserve indicates it will make some changes that may well affect bond prices. These changes include pulling back from its monetary policies of both Quantitative Easing (buying treasury securities to increase lending and liquidity) and Operation Twist (buying and selling bonds in order to lower long-term interest rates). In all likelihood, the Fed will also set a higher Fed Funds rate (the rate at which they loan money to banks).
All of this could negatively affect bond prices, which tend to move in the opposite direction of interest rates. The major issue for investors, here, is that it will take longer for interest income to offset a loss in principal (due to inverse relationship between interest rates and bond prices and the fact that we are in a low interest rate environment). So if your investment strategy centers on creating a reliable fixed income portfolio, there are ways to reduce interest rate risk in a rising interest rate environment. But it will take some planning to stay ahead of the curve.
One way to mitigate risk is to lower the “duration” of your bonds to no longer than three years. Duration measures the price sensitivity (the value of principal) of a fixed-income investment to changes in interest rates. Duration is also a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. Why does duration matter?
Duration is an important measure for investors to consider because a bond with a higher duration carries more risk and has higher price volatility than a bond with a lower duration.
A number of other strategies can work to your advantage in a rising interest rate environment. Be sure to speak to your advisor before deciding which of the following might work best for you. Here are some options worth considering.
Create a Certificate of Deposit (CD) or a Bond Ladder Strategy, an investment strategy wherein you purchase several CDs or bonds that mature across several different years. By using a ladder, you ensure money is available periodically and you may be able to reinvest at higher rates in the future.
Develop a diversified, low duration income portfolio that includes Treasury Inflation Protected Securities (TIPS), Floating Rate Notes (FRNs), Emerging Markets Debt, convertible bonds, corporate bonds, and high yield bonds. What are these, and how can they work to your advantage?
- A TIPS is a treasury security that’s “indexed to inflation,” meaning it helps to protect investors from the negative effects of inflation and is designed to preserve the purchasing power of your dollar. Dollars invested today should have equal purchasing power in future years.
- Floating rate notes are bonds that have a variable coupon equal to a money market reference rate (such as the Fed Funds Rate), plus a quoted spread, which is a rate that remains constant. FRNs carry a low interest rate risk because the principle does not decline as interest rates risk because of this adjustment.
- Emerging markets bonds are issued by either a corporation or the government of a developing country. Returns have generally been higher than in developed countries due to higher yields to compensate for increased risk.
- A convertible bond can be converted into a predetermined amount of the company’s stock at certain times during the bond’s life, usually at the discretion of the bondholder. The benefit is if the stock price outpaces the bond yield.
Employ alternative strategies, such as a fixed or equity-indexed annuity, which provide a guaranteed minimum return, or a variable annuity with a Guaranteed Living Withdrawal Benefit. Here’s what they are, and why they’re worth considering.
- Fixed annuities are essentially CD-like investments issued by insurance companies. Like CDs, they pay guaranteed rates of interest, in many cases higher than bank CDs. These are best suited for taxable account assets and for investors who want a preservation of capital strategy.
- Equity-indexed annuities offer the low-risk appeal of a guaranteed minimum return (usually 1 percent in today’s market) with some upside: since an equity-indexed annuity’s return is also tied to the performance of a benchmark index, such as the S&P 500, with these products you have a shot at higher gains if the stock market rises.
- A Variable annuity is a contract with an insurance company that allows you to invest in one or more investment options (called subaccounts). It’s essentially a traditional investment portfolio with insurance added to protect future income from market risk. The GLWB feature makes it best suited for investors with limited or no defined pension resources to help address longevity risk.
What else do I recommend? Additional options to consider with your broker/advisor include using life insurance as an asset class as part of an overall financial planning strategy, delaying claiming Social Security, and increasing mortgage prepayment.
A wealth management advisor can help you to solidify your investment strategy and plan for your future. Please click here to download my eBook, which dives deeper into this topic or feel free to contact me at firstname.lastname@example.org.