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Portfolio > Economy & Markets > Fixed Income

Protecting Portfolios From Interest Rate Risk

By Ryan Nauman

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What You Need to Know

  • Inflation is likely to rise, causing the Federal Reserve to raise interest rates, which is bad for bondholders.
  • High-yield bonds are less sensitive to interest rate movements.
  • Low-duration bonds' steady performance makes them attractive on a risk-adjusted basis.

Fixed income investors have enjoyed a stellar 40-year bull run that has produced a 7.52% annualized total return for the Bloomberg Barclays U.S. Aggregate index through March 2021, while falling 10-year Treasury yields have been the wind in the sails for bonds.

Yields on 10-year Treasury have been on a long and steady fall from 15.84% in 1981 to their all-time low of 0.52% in August 2020, which has boosted bonds and supported expanding equity multiples along the way. The stellar fixed income run, however, is under immense pressure as inflation could derail the 40-year trend of falling Treasury yields that has supported bonds.

Bonds, including corporates and Treasurys, have benefited from muted inflation and a continuous slide in Treasury yields, But those trends look to be on the verge of ending. Treasury yields look to be on their way to 2% after rising over 120 basis points since hitting August lows. Massive fiscal stimulus, stronger economic growth and inflation expectations have pushed Treasury yields higher.

The outlook for economic growth continues to rise north of 7% following the passage of the massive American Rescue Plan, ongoing accommodative monetary policies and a ramp-up in vaccinations. This is great news, particularly to holders of risky assets like stocks.

However, this macroeconomic backdrop may not be music to the ears of investors who rely on a steady stream of investment income. The strong economic growth is likely to boost inflation, eventually causing the Federal Reserve to raise interest rates, which is a bad combination for bondholders. 

Due to years of declining yields, bond duration has increased and has become a real threat to prices — especially now, with the expectation that rising inflation will likely lead to higher interest rates.

Duration is a measure of the approximate price sensitivity of a bond to interest rate changes. Specifically, it is the approximate percentage change in price for a 100-basis-point change in interest rates. These higher interest rates will negatively affect bonds, particularly those that are more sensitive to interest rate movements (long duration).

Due to growing interest rate risk, the term “risk-free return” may not hold true; in fact, it may be more accurate to use Leon Cooperman’s wording, “return-free risk.” With this backdrop, the question is: Where do investors look to generate the required income while risk in historically low-risk assets has increased? 

The first place to look is bonds with low duration, or sensitivity to interest rate moves. For example, if interest rates rise 1%, a bond with an average duration of five years would lose approximately 5% of its value.

Generally speaking, bonds with low coupons and long maturities, like Treasury bonds, are more susceptible to interest rate changes. Meanwhile, bonds with higher coupons and shorter maturities, such as high yield bonds, have lower durations or are less sensitive to interest rate movements.

Figure 1 compares the performance between a low-duration manager, a high-duration manager and a high-yield index. As you can see, during the 40-year period when yields were on a consistent down trend, the high-duration manager outperformed by a wide margin. When Treasury yields started their ascent in August, however, the higher duration manager faltered while the low-duration manager outperformed.

Figure 1: Source: Zephyr; Long Duration SMA vs. Low Duration SMA

As you can see in Figure 1, low duration bonds are not going to overwhelm you with eye-popping total returns, but their steady performance and low standard deviation make them more attractive on a risk-adjusted basis (Sharpe ratio) compared with long duration and high yield bonds.

Below are some of the top separately managed accounts found in the PSN SMA database with durations between one and three years and superior three-year risk-adjusted returns (Figure 2).

Figure 2: Sources: Zephyr, PSN database; data: three years as of 2/2021

Despite concerns that higher yields will hurt lower-quality bonds as borrowing costs for these lower-rated companies increase, the benefits of the strong economy and solid financial conditions should offset the higher costs.

In addition to high-yield bonds, look to bank loans and floating-rate bonds, which are a hedge against rising interest rates. Figure 3 displays some of the top high-yield and floating-rate bond SMAs that are found within the PSN SMA database with durations of less than five years and superior three-year risk-adjusted returns. 

Figure 3: Source Zephyr, PSN database; data: three years as of 2/2021

Lastly, if your clients are not dependent on investment income and are comfortable with more exposure to equities, you may want to consider increasing their allocation to equities — particularly sectors and styles that benefit from higher yields and greater economic expansion like financials, cyclicals and small-caps. 

After decades of relying on total returns with low risk from high-quality bonds, financial advisors are now faced with replacing the stellar total returns, solid income and diversification benefits that have anchored client portfolios for years with alternatives that reduce interest rate risk but bring their own obstacles. 

Ryan Nauman is a market strategist at Zephyr. His market analysis and commentaries are available at https://financialintelligence.informa.com.

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