The Risk of Safety – Your Fixed Income Portfolio in a Rising Interest Rate Environment

This article, authored by Kyle Rudduck, CFA, Vice President, Wealth Strategy and Portfolio Manager, NB&T Wealth Management Group, appeared in the Wilmington News Journal on September 17, 2013.

A golfer’s short irons are typically their “safe” clubs – those that they turn to when they are risk averse on a certain shot and absolutely have to keep the ball in play and/or when they are close to the green and trying to finish off the hole. Using a short iron sacrifices distance for safety. Applying this concept in a different context, there are many similarities between a golfer’s short irons and the fixed income component of an investor’s portfolio. An investor commonly turns to fixed income when they are risk averse and principal protection is of primary importance and/or when they are closing in on retirement and willing to sacrifice potential return for a more stable income stream. While fixed income is traditionally thought of as a very safe investment, in today’s current interest rate environment, the risk of that safety should be carefully evaluated.

Historically record low interest rates, a stabilizing national economy, and fears that the Federal Reserve will begin “tapering” its $85 billion a month asset purchases have all been fueling a recent rise in interest rates. As a result, investors that have historically relied heavily on fixed income funds to provide a stable income stream while also focusing on principal protection are, for the first time in years, beginning to see losses on their monthly statements. That is because fixed income asset prices move inversely to the direction of interest rates -- as interest rates rise, the value of a fixed income investment declines and vice versa. To use a golf analogy to demonstrate why this happens, consider the following: when new golf clubs come onto the market incorporating new technology allowing you to hit the golf ball further, all else equal, you would pick those clubs. In order for the older clubs to have a chance to continue to be purchased, their price would have to be reduced to provide an incentive to the consumer that would offset the benefit of the increased distance offered by the newer ones. Similarly, all else equal, an investor would always prefer to have a higher interest rate on their fixed income investment. Therefore, as new investments come onto the market at higher interest rates, an investor would need an incentive to cause them to purchase the older instrument now paying a below market rate. Thus, the price falls. While the best hedge against losses over the long term is a diversified portfolio invested across various assets and asset classes, investors do have certain tools at their disposal to help evaluate their current level of risk.

At a high level, a good way to determine how exposed your fixed income portfolio is to rising interest rates is to examine the portfolio’s “duration.” Duration effectively measures how much of a price decline one can expect should interest rates change by +/- 1.0%. For example, a duration of 5.4 years would imply that, should interest rates increase by 1.0%, the investment would be expected to decline in value by 5.4%. Conversely, should interest rates fall by 1.0%, an investor would expect that investment to appreciate by 5.4%. In today’s environment, where the yield on the 10 year treasury has increased from approximately 1.6% in May to just under 3.0% currently (and is expected to continue to climb), investors would be wise to shorten their portfolio’s duration thus helping reduce their portfolio’s exposure to adverse interest rate movements. While the actual calculation of duration is rather complex, the data point is commonly provided with the general information one receives when researching fixed income investments.

As referenced earlier, over the long term, the best hedge against rising interest rates is a diversified portfolio. Interest rates typically rise when the economy is growing and expected to continue to perform well -- a positive sign for stocks. As such, traditionally a good way to hedge the price declines of fixed income is to have an equity exposure that would appreciate in value helping to offset such losses. The amount of equity exposure one should have depends largely on a variety of factors such as: life stage, risk tolerance, and total investable assets (among others) but having some exposure to equities, especially in today’s environment, can greatly help reduce value fluctuations in your portfolio.

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