November 1, 2012

Ragtops and Higher Rates—Searching for Alpha for November 2012

One of the most often-asked questions I receive is the potential impact of higher interest rates on portfolio returns. Investors seem aware that rates are extremely low—and artificially so, give the Fed’s easy money policy—but that they may return to historic norms.   

The catalyst for higher rates could have economic or market-based origins. Stronger economic growth might cause the Federal Reserve to rethink its dovish mindset and put the brakes on asset purchases, which could potentially cause higher short-term rates. Or market participants might start selling Treasury debt for the potential for higher returns in equities. Either scenario could lead to higher rates.

Advisors may want to considering adding convertible bonds if one of these scenarios unfolds. These unique fixed-income securities typically have a coupon and can be converted to stock under certain circumstances. Convertibles are sometimes referred to as “hybrid” securities, since they share characteristics of both equity and fixed-income asset classes. And the combination is unique, as it generates a return stream that has historically been unaffected by rising rates.

Why is this? First off, the conversion feature makes convertibles rise as volatility increases. And the equity-linked nature of these securities allow them to enjoy gains as rates rise, making them relatively immune to interest rate hikes. Converts should be considered as a logical portfolio addition in a rising rate environment.

 

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