Managing the risk to bond portfolios from rising interest rates

Interest rates have seemingly stabilized between 2.4% and 2.6% on the 10 year US Treasury since the jump in rates between May and June. A strengthening economy (hopefully) over the next several years is expected to be accompanied by further increases in the 10 year yield; most likely to a more normal 4-5% range. I’m not going to argue whether this will happen in today’s blog, but rather how can an investor cushion his bond portfolio (or the bond portion of his overall portfolio).

The current approach by many investors and advisors fleeing intermediate high quality bonds in the wake of the recent run-up in rates has been to either get out of bonds or to take on significantly more credit risk, especially in the high yield and floating rate note arenas. While I agree that a bond portfolio with a higher yield should cushion a rise of interest rates to some degree, investors need to be careful here. I’m not so much concerned about the credit risk at this point of the cycle, but rather the volatility and potential downside that overweighting these two areas may bring to a portfolio.

The challenge is especially acute for investors using managed investments as some core managers may have also taken on additional credit risk and an investor may find he has a large portion of his assets in higher risk bond areas that are subject to principal downside risk along with equities. I think the watchword needs to be….flexibility.

Investors should consider increasing the flexibility of their bond portfolio. So, perhaps having a portion with a manager who specializes in foreign bond investments can help diversify from US centric bond risk. Additionally, a multi-sector manager (think go-anywhere or unconstrained) may help as well. Also, a core manager with maybe a focus on potentially higher yielding mortgage-backed securities or potentially higher-yielding investment grade bonds should be considered. Yes, a floating rate note manager can also play a part as this type of bond should be able to reset its interest rate periodically to take advantage of the higher rates. Additionally, this type of bond has historically had a high correlation with inflation.

Additionally, investors may want to consider more unconventional managers. Perhaps those who have the ability to short the bond market when rates are rising can add a layer of diversification for investors.

There is no easy strategy, but hopefully this helps you see there are other alternatives beyond dumping bonds indiscriminately or loading up on high yield (and potentially higher risk) bonds.