Interest rates are near their lows, credit spreads are compressed, and you have to make a fixed-income allocation on behalf of your client. What should you do? How do you decide?
Most fixed-income allocation decisions are based on feel or intuition. Longer bonds feel more dangerous, and everyone knows rates are going to rise. But is using intuition and conventional wisdom a good way to invest?
Too often, decisions are executed based upon using top-down analysis like “rates will rise,” making an entire strategy dependent on the quality of the interest rate call. If your interest rate call is wrong, your strategy is doomed. Would it not be better to make measurements based on how much a rate rise would hurt portfolio values, or plan for the possibility that rates don’t increase?
The typical analytics for fixed income allocation has been to use yield and duration. The problem is that these are tools of limited measurement. Furthermore, they are static, capturing only today’s interest rate environment. Since your clients will own their investments over time, a snapshot of today’s bond price is not enough information to make a decision.
A better system is to use dynamic measurement, which takes into account income and an investment’s price sensitivity over time, in different interest rate scenarios. Future value measurements are often used for equity allocations. The same technique can be used to present value (PV) the future cash flows on fixed income securities. This allows managers to make more fully informed decisions and make more robust comparative allocations.
One of the best ways to measure bond behavior in multiple interest rate environments is with “scenario-based total return.” This framework allows you to dynamically estimate what happens when rates go up, go down or stay unchanged and quantify the income a client can receive over the holding period. For example, a typical scenario could be posed as: what is the coupon income received, and ending value of the client’s portfolio, if rates rise 150 basis points in one year, or if rates rise 300 basis points in three years?
For the defined scenario, we can estimate the cash flows received over the holding period, PV the future cash flows and observe the change in portfolio value.
For the past 30 years, fixed-income investment has been in a bull market as rates generally declined, and conventional allocations to bond funds, ETFs and building bond ladders have worked. Now that we’ve reached the trough in rates, it’s time to consider a new strategy that considers the variables.
Scenario-based total return offers a more dynamic way to measure wealth over various interest rate environments. Now, given certain assumptions, you can answer those tough questions: “When do I win/lose? How much do I win/lose by? And for how long do I win/lose?”