Anxiety prevails among fixed income managers over the prospects of rising interest rates and what it will do to their product’s reputation as a “safe” investment. Although the Fed recently signaled that it will not be raising rates immediately, the specter remains for investors who thought they were buying safety only to see their bond funds systematically erode as rates start to rise.
Many investors do not understand the counterintuitive nature of the inverse relationship between interest rates and bond values. Those who looked to bonds to protect their portfolios from the volatility of 2008 probably do not realize that the value of their bond portfolios will get hammered as interest rates rise. They assume that the lower volatility of bond funds means that their portfolio cannot lose value, which of course is not true. In fact, some bond fund vendors are beginning to issue warnings to customers that they should consider diversifying out of bond funds so the hit will not be quite so bad when the rates actually begin to climb from their current historic lows.
How bad can the hit be? A Schwab analyst suggests that, for bond portfolios with an average duration of five years, every percentage point rise in interest rates will cause the portfolio to drop in value by about 5%. There are a lot of technical assumptions behind that estimate, but it gets the point across.
Investors holding bond funds because they think they will be shielded from market fluctuations will be sorely disappointed, but not all bond investors will be hurt by rising rates. For example, retirees (or anyone else) buying fixed income to create predictable cash flows by laddering individual bonds and holding them to maturity will not be harmed by the intervening paper losses on their bond holdings. In fact, these bond investors may welcome cheaper bonds because they will make the cost of continuing the cash flows cheaper. By holding individual bonds instead of bond funds, investors who need to generate income from their portfolio can actually take advantage of rising interest rates and immunize their cash flows. College textbooks, both old and new, refer to the idea of holding bonds to produce cash flows as a “dedicated” portfolio strategy.
The Tale of Two Bond Investments
Investors generally gain exposure to fixed income either through funds or through individual securities. Bond funds and individual bonds serve fundamentally different roles, particularly for retired investors looking to generate income from their portfolios. Bond funds are designed as total return vehicles that seek to deliver lower volatility than stocks. The goal is to grow faster than withdrawals. However, the underlying characteristics of bonds are lost when they are aggregated in a single portfolio that serves thousands of clients. Although bond funds have low volatility, this doesn’t mean that they can’t lose money, which is exactly what will happen in the short run as rates rise. An investor would still have to sell shares in order to generate income, magnifying the negative effect of reverse dollar cost averaging.
The unique characteristics of individual bonds, on the other hand, can be engineered to deliver predictability along with low volatility. The amount of coupon interest and the timing of maturities for individual bonds are known when the investor buys the bond. So with a little timing, you can match the cash flows using the coupon and redemptions so that the portfolio will be completely immunized from changes in interest rates (since you hold the bonds to maturity) and perfectly match the duration of the income stream regardless of the type of shift in the yield curve.
Liability Driven Investing for Individuals
It used to be that individuals could rely on a pension from their employer to deliver predictable retirement income. Now, most individuals are left to their own devices to generate income from their portfolio. But the pension fund and the individual face the same challenge, building a portfolio to match the projected future income stream. In the institutional investing world, this approach is referred to as “liability driven investing” (LDI), also called goals-based investing
LDI can be implemented with individuals through dedicated (cash-matched) bond portfolios. The idea of a dedicated bond portfolio is to synchronize bond maturities and coupon payments to precisely match future cash flow needs and then hold the bonds until they mature. The cash flows, of course, are the withdrawals retirees must make each year to pay their living expenses. Individual bonds can supply perfectly timed cash flows year after year, without missing a beat. That is why they are called “fixed income” instruments.
Immunization and Predictability
Like its cousin the bond ladder, a dedicated bond portfolio is immunized against rising interest rates because the individual bonds are held to maturity. The value of the portfolio itself is not protected from rising interest rates, but the cash flow stream produced by the bonds is protected. By taking this cash-generating portion of the portfolio off the table risk is nullified where it counts.
Providing predictable cash flow is precisely what a dedicated portfolio is dedicated to do. In fact, holding U.S. Treasuries, agencies, CDs, and TIPS to maturity is probably the closest thing to perfect predictability that exists when it comes to future cash flows. Unlike a bond fund, retirees do not have to worry about what will happen if interest rates are up (and their portfolio value is down) just when they have to sell to get cash for living expenses.