Fixed-income Investing, When Interest Rates Rise
February 22, 2013
Although rising interest rates may challenge those bond investments with the highest sensitivity to interest rates, many parts of global fixed-income markets can provide reduced interest-rate risk and even be used to seek potentially strong performance in a rising interest-rate environment.
Spread sectors (such as U.S. investment-grade corporates, emerging market debt, high yield and bank loans) historically have had lower correlation to more interest-rate sensitive sectors such as U.S. agencies and U.S. mortgage-backed securities. This means there are three main investment strategies that can be utilized within a rising rate environment.
Let's take a closer look at the following approaches:
Credit-oriented strategies-Credit sectors historically have been more correlated to the overall economic outlook and corporate earnings landscape than interest rates, and they may perform well in a rising rate environment.
Short duration-oriented strategies-Short-duration securities typically have lower sensitivity to interest rate changes than their longer-duration counterparts. Strategies investing in shorter duration securities or sectors can seek to capitalize on the higher income from rising rates more quickly than longer sectors and, thus, potentially reduce interest-rate risk.
Globally oriented strategies-Investing globally offers diversification through non-U.S. dollar yield curves and currencies and can seek to capitalize on the differing business cycles and economic conditions present around the world.
As mentioned earlier, credit sectors historically have been more correlated to the overall economic outlook and corporate earnings landscape than interest rates. Improved balance sheets and liquidity, healthier credit ratios and increased credit availability may help reduce the impact of rising interest rates.
There are various credit-oriented strategies that can be used to seek potentially strong performance, as well as reduce risks associated with rising interest rates.
Strategic income or multi-sector fixed income-This strategy typically invests across multiple sectors of the fixed-income universe, including various credit sectors, seeking to help reduce interest-rate risk.
High income-This is a strategy that focuses predominantly on lower-quality credit sectors and tends to be more correlated with economic growth than higher-quality credit sectors.
In general, bond prices and interest rates display an inverse relationship, such that as interest rates rise, a bond's price will fall. Short-duration securities are generally not as sensitive to rate movements and can offer an attractive alternative to intermediate or longer-duration exposures where rising rates typically have a greater effect on price and valuations.
Securities with a longer time to maturity are exposed to greater uncertainty surrounding the economic outlook or business cycle and, thus, tend to exhibit higher volatility than shorter-maturity securities. The primary reason shorter-maturity securities tend to exhibit less volatility is that they are less exposed to the economic cycles and uncertainty surrounding the economic environment, which tend to span longer time frames.
Consequently, shorter-duration securities can be used to seek to capitalize on rising interest rates more quickly than longer-duration securities, as their return of principal at maturity can be reinvested quicker at the new, higher interest rate than securities that have not yet matured. This reinvestment at higher interest rates may help total return potential over time.
There are various strategies and security types with short-duration qualities that we believe can help reduce risks associated with periods of rising rates. These include:
Low duration total return-a multisector strategy that generally invests in short-duration, high-quality securities across a variety of fixed income asset classes.
Bank loans-This strategy invests in loans made by banks and other financial institutions to below-investment-grade corporations and are, in general, fully secured by the assets of the borrower.
Absolute return-This strategy typically involves dynamically hedging pure interest-rate risk to try to reduce volatility from shifts in interest rates.
Broadly speaking, global interest rates will rise over the longer term. However, in the near term the ongoing divergence in the timing of rate changes across various economies, which have different underlying economic drivers, is likely to continue.
As central banks in many of the major developed markets, such as the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank, continue implementing unorthodox quantitative easing programs, short-term interest rates are likely to be somewhat anchored over the near term.
However, to the extent certain economies begin to recover, including seeing improvements in unemployment rates, and experience economic growth over the intermediate term, this may lead to upward pressure on interest rates over time.
Given this backdrop, opportunities exist in global fixed-income markets in a rising rate environment through credit, short-duration and globally oriented strategies.
Although these investment strategies may assist investors in reducing interest-rate risk, other risks do need to be considered.
These include credit risk, which is the risk of a downgrade or default, as well as currency risk, in which the depreciation of a currency can negatively impact the value of the securities in a portfolio.
Chris Molumphy is the CIO of the Franklin Templeton Fixed Income Group.
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