Rising interest rates make bond investors nervous because it impacts on asset management and therefore wealth management, but purging your portfolio of interest rate risk can be a detriment to your ultimate investment earnings. There is a better way to balance risk and return.
Always consult your financial advisor before making changes to your wealth management strategy.
Besides making careful decisions on asset allocation and diversification, Investors can minimise risk and maximise return from a fixed income portfolio by pairing rate sensitive assets such as government bonds with growth orientated credit assets in a single portfolio and letting their fund managers adjust the balance as conditions change.
Fixed-income assets come in two varieties: risk-reducing and return-seeking. Most of the time, they add value at different times and in different market environments.
A key benefit of this approach, known as a credit barbell strategy, is that it helps investors avoid leaning too far in either direction and over exposing themselves to a single risk.
For example, when investors see bond yields rise sharply, the first thing they do is reduce the duration. Duration is a measure of the sensitivity of the price of a bond — in other words the value of the principal — of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Bond prices are said to have an inverse relationship with interest rates.
Reducing the duration in a core bond portfolio, would involve selling longer dated bonds and purchasing shorter dated bonds. This would be achieved inside investment-grade debt with a healthy share of government bonds.
Secondly investors take more credit risk being a higher allocation to high income high yield bonds, such as emerging market debt and other credit assets which tend to perform well when growth and interest rates rise.
High-yield bonds, a return-seeking asset, and US Treasuries, a risk reducer, took turns outperforming each other more than half the time over the last two decades. Pairing them in a single portfolio allows an investor to rebalance regularly by selling the outperformers and buying the underperformers. Over time, that can minimize drawdowns and provide a relatively high level of income.
But herein lies a problem, cutting back drastically on interest rate sensitive assets such as Treasuries or mortgage-backed securities can make a fixed income portfolio less diverse and therefore less stable. Always remember as these bonds mature, their prices drift back toward par. That means investors can reinvest the coupon income in newer high yielding bonds.
But here’s another thing about bonds: they’re very good at generating income. That means they often generate positive returns even when their prices decline. Over the last 20 years, high-yield bonds and US Treasuries did that 41% of the time.
Income accounted for nearly all the average quarterly return of US Treasuries over the last 20 years, a period when yields fell sharply and prices rose. High yield bonds of course, relied even more heavily on income to drive returns, as price movement was negative.
This illustrates why rate sensitive assets should always have a seat at the asset allocation table. It also helps to explain why a skilled active fund manager who pairs them with return seeking assets such as high yield bonds and adjusts the balance as needed has the potential to produce relatively high returns.
Of course, investors who lean too heavily toward return seeking assets might be taking on more credit risk than they want at a time when many corporate bond valuations look stretched and some credit cycles particularly in the US are in the twilight stage.
Also, high yield bonds and other return seeking credit assets are more closely correlated to equities than they are to the rest of the fixed income universe. That means a strong bias towards credit can lead to a less diversified investment portfolio.
It is always worth remembering rising rates eventually lead to slower growth. When that happens credit cycles fizzle out, growth sensitive assets struggle and interest rates eventually fall.
A credit barbell strategy allows a good fund manager to see this interplay between global interest rate and credit cycles more clearly and to bias the portfolio slightly toward one or the other without putting investor portfolios out of balance.
That’s a lot harder to do when you assign your rate sensitive and growth sensitive assets to separate portfolios run by separate fund managers.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all North Financial Advisors Pty Ltd representatives.