In times of market uncertainty, a strong fixed income component can be a nice safety net for your portfolio. Its inherent stability, combined with its tendency to move in opposition to equity markets, may help you to sleep better when stocks are under pressure. But fixed income instruments can be subject to their own volatility, particularly when interest rates start to move. And interest rate fluctuations may end up costing investors, says Ira Mark, an RBC financial advisor, so it’s wise to be well-informed.
“In a falling rate environment, there is always reinvestment risk,” says Mark, who’s with the RBC Wealth Management-U.S. team in New York. When rates drop, investors can no longer count on the income they’re accustomed to receiving. “And in a rising rate environment,” says Mark, “there is always potential for the bonds to go down in value.”
Interest rates are near historic lows. As a result, many investors feel that rates can only go up. However, in the current environment of low inflation, slow global growth and accommodative central banks, interest rates may very well stay low for some time to come. Recent statements from the Federal Reserve suggest that it will be patient in normalizing monetary policy, with future rate hikes dependent on global economic and financial developments. Market expectations currently suggest the next rate hike is likely to be a 2017 event.
But whether the trajectory moves up or down, investors should understand the impact of changing rates and how they affect their investment options. Here are six strategies to help fixed income investors deal with the potential for rising, falling or flat interest rates.
Strategies for a low-rate environment
Investors often embrace short-dated bonds because of their low risks. But if interest rates decline, investors run the risk of having to reinvest the proceeds of maturing bonds in less profitable, lower-yielding instruments. “It makes the case for investors to go against their natural inclination to stay short, thinking they’re playing defense,” says Craig Bishop, RBC’s lead strategist for U.S. fixed income strategies based in Minneapolis. “With rates staying lower and potentially going lower, that’s more of a losing proposition,” says Bishop. Mark agrees, saying he typically recommends going long in a low-rate environment.
Instead, Bishop suggests investors consider longer-dated bonds, focusing on corporates and municipals, which boast higher rates than government treasuries. Which one you choose could depend on your income level, as municipal bonds are tax exempt at the local and state level, but typically offer lower yields than corporates, which are taxable and have a higher risk of default. For corporates, consider a mix of bonds with average maturities around 6 to 8 years out. For municipals, this “sweet spot” is farther out on the yield curve. Mark, who specializes in municipal bonds, helps clients focus on opportunities in higher coupon issues with long maturities of 15 to 20 years, and intermediate calls of approximately 10 years.
Fix the rate
The ultra-low rates of the past few years have prompted many to invest in floating-rate securities in anticipation of a sudden rate increase. But in a flat-to-lower rate environment, investors should consider going fixed; if rates decline, your fixed yield will look better in comparison. In a low-rate environment, Bishop suggests taking on preferred shares, which offer higher yields than bonds but share some of the same characteristics, including interest rate sensitivity and regular payments.
Be picky with yield
The challenge of a lower-rate outlook in an environment that’s already pushing historical lows is that traditional bonds simply don’t pay enough to be worth the hassle. Yet a sizable fixed income component is a necessity for any portfolio. The search for yield can prompt investors to take on more risk, but Bishop advises caution.
“Lower rates potentially indicate that there could continue to be some stress in the economy,” notes Bishop, “so I think it makes sense for investors to be selective with their investment decisions.” This means focusing on BBB rated corporates, which are slightly riskier than A or higher-rated bonds, but offer better yields.
You could consider mixing in some high-yield debt (below BBB rated), but this involves higher risk and more research. And with continued volatility in oil prices, it’s wise to remain cautious on adding exposure to the energy sector, says Bishop.
Strategies for a rising-rate environment
Let the rates float
With the Fed expected to hike rates eventually, some observers believe interest rates may be on the cusp of a sustained upward push. If so, then floating-rate securities offer protection by pegging the yield to a benchmark rate, such as the London Interbank Offered Rate, or LIBOR.
Bishop suggests looking at fixed-to-floating rate securities, which offer a fixed rate for five or 10 years, then become a floating-rate instrument. The benefit of this hybrid instrument is that the initial fixed rate is likely higher than what you’d get on a straight floating-rate security, and when it converts to a floating rate, you’d be protected against rising rates.
Climb the ladder or lift the barbell
Perhaps the toughest part of investing in an uncertain rate environment is predicting when yields will begin to rise. Investors can sidestep this entirely by using a ladder or barbell strategy, which combine short-term flexibility with long-term yield.
With a ladder, investors spread out fixed income investments into securities that mature over a range of years. For instance, rather than investing $20,000 in a bond that matures in five years, invest $4,000 in five bonds that mature in one, two, three, four and five years. If rates rise, the maturing bonds can be invested at a higher rate, boosting the overall return. But if rates fall, investors are protected, as only the shorter-term bonds would be reinvested at the lower rate.
Similarly, the barbell involves investing in both short- and long-term bonds, while avoiding bonds of intermediate length. “The short end of the barbell will allow an investor to take advantage of short rates that are still better than cash; the long end of the barbell will allow an investor to capture higher yields,” says Bishop.
And the kicker
Another opportunity specific to municipal bonds, according to Mark, is an instrument called a “kicker bond” due to its built-in call features on issues with maturities of more than 10 years. Kicker bonds offer investors a way to increase yield without sacrificing credit quality, says Mark.
Because kicker bonds have higher-than-current-market coupons – 5 percent versus 2.50 percent, for example – they usually offer stronger yields and higher cash flow than typical bonds, with one important difference. A kicker bond can be redeemed or “called” by the issuer well ahead of its maturity date, which means an investor would have to invest the funds elsewhere if the bond is called. But if it’s not called early, the investor’s yield rises or “kicks up” as the effective maturity of the issue extends. It’s important for investors to understand the built-in uncertainty of the potential call, says Mark, but also to recognize that the risk is offset by a higher yield.
Ultimately, investors should take an active interest in managing their portfolios. In the current interest rate environment, simply investing and forgetting is not recommended. “Even though we continue to believe interest rates will remain low,” says Bishop, “if investors don’t know what type of security they are considering and don’t understand the risks when they choose a bond for their portfolio, the overall performance could suffer.”