Most investors are aware that interest rates are near record lows. Yields on almost $8 trillion of global government bonds have been driven to near zero by worries over global growth, and unprecedented debt purchases by central banks. However, many investors do not understand the extent of the risks to their bond portfolios in a potential rising-rate environment. And because any complacency can be dangerous, it’s essential that those investors understand these risks.
Since the 10-year Treasury rate peaked at nearly 16 percent in 1981, bonds have been in a 35-year bull market. Many investors have never seen a bear market in fixed income. Today, 30-year U.S. Treasury bond yields are under 2.5 percent, which is less than half of their 6.8 percent average over the past five decades. Just a 1 percent yield increase on that instrument would produce an estimated decline of nearly 20 percent.
This prediction is based on a metric called duration. Duration is the approximate percentage change in price that would occur with a 1 percent change in interest rates. It would take a fairly small move up in rates on the long end to wipe out your annual return. This could prove to be a problem for investors depending on bonds for downside protection and low volatility.
Those who pay no attention to interest rates may miss out on valuable opportunities and shocks to their fixed-income portfolios.
As we are likely entering a period of rising rates, we believe it is important to analyze the sensitivity of clients’ bond portfolios to a rising interest-rate environment. This can be accomplished with a Horizon Analysis report. This model will calculate the approximate total return for an investor’s bond portfolio over a specified time horizon and interstate scenario.
Horizon Analysis allows an investor to assess the portfolio’s performance under different interest-rate scenarios, i.e., an increase of 25 basis points, 50 bps, 75 bps and 100 bps, versus a similar decrease over a specified horizon date. This type of analysis will allow investors to estimate expected gains and losses on their bond portfolios over a given period. We believe this modeling will assist investors in better understanding the potential volatility expected in a rising-rate environment.
Meanwhile, this exercise begs the question: “How do you protect your fixed income investments as rates rise?” I believe that the number one essential element for fixed-income investors today is the flexibility of active management.
Several ideas to weather the storm include shortening duration and buying short-term bonds. While these prices may also fall, they do not fall as fast or as far as longer duration bonds.
Bond laddering will also help your bond portfolio. This simply means buying individual bonds with staggered maturities and holding them until they mature. Such a strategy allows you to use the higher rates to your advantage by reinvesting the proceeds from the maturing bonds, in newly issued bonds with higher coupon rates.
In addition, floating-rate loan bonds can benefit as rates rise. As interest rates rise, so do the coupon payments on these loans. This helps bond investors in two ways: It provides more income as rates rise, and keeps principal value stable.
History dictates that interest rates will not stay low forever, but when rates will rise and how far they’ll climb is difficult to predict. Those who pay no attention to interest rates may miss out on valuable opportunities and shocks to their fixed-income portfolios. That’s why it’s so important to understand your risks and prepare now.
David P. Bieber is a Wealth Advisor with the Wealth Management division of Morgan Stanley in New York, NY. Morgan Stanley Financial Advisor(s) engage Worth to feature this article. David may only transact business in states where he is registered or excluded or exempted from registration, www.morganstanleyfa.com/david.bieber. Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where David is not registered or excluded or exempt from registration. The strategies and/ or investments listed may not be suitable for all investors. © 2016 Morgan Stanley Smith Barney LLC. Member, SIPC. CRC597321 11/16
This article was originally published in the December 2016/January 2017 issue of Worth.