Fixed income investments play an important role in a well-diversified portfolio, serving as downside protection and portfolio ballast in times of uncertainty. But this year’s environment has some investors concerned about the risk of rising consumer prices on their bond portfolios. The Fed’s position has been that the inflationary pressure we’ve been seeing is transitory. Nonetheless, many of your clients may be looking for fixed income investment strategies that could insulate their portfolios against inflation risk.
Although there is no way to completely avoid the impact of higher inflation on fixed income, the risk can be mitigated. Let’s review four strategies you should consider for help managing risk in a fixed income portfolio.
1) Shorten Duration
For fixed income investors, the primary concern regarding rising inflation is the potential for interest rates to rise. Rising interest rates put pressure on fixed income investments by causing prices for existing bonds to fall. This is known as interest rate risk.
Duration measures a fixed income investment’s sensitivity to a given change in interest rates, with higher-duration investments typically seeing more price volatility for a rate change. A bond with a duration of 5, for example, would be expected to see its price fall 5 percent if interest rates were to rise by 1 percent. In comparison, a bond with a duration of 2 would be expected to see a 2 percent decline in price for the same change in interest rates.
To combat a rise in rates, shortening the duration of a portfolio is one of the first fixed income investment strategies you might consider. This strategy aims to lower the interest rate risk for the portfolio. With that said, given the current overall low interest rate environment, shortening duration alone may not ensure that a portfolio is adequately protected while generating a reasonable return.
2) Increase Spread Risk
Another popular strategy for managing risk in a fixed income portfolio is to orient allocations away from interest rate-sensitive products and toward spread-based products. Investments in the spread-based category include corporate bonds, mortgages, and high-yield investments.
These investments are a step out on the risk spectrum compared with investments that are historically interest rate sensitive, such as long U.S. Treasury bonds, but the risk is concentrated on credit risk. Corporate bonds, mortgages, and high-yield investments are typically driven by improving economic fundamentals. As a result, they can benefit from rising rate environments that see faster economic growth. Given the drivers of the recent inflation increase —namely reopening efforts and economic recovery—spread-oriented investments may make sense for your clients’ portfolios.
It’s important to note that corporate bonds, mortgages, and high-yield investments are not immune to the negative effect rising interest rates may have on prices. Nonetheless, the shift from primarily interest rate-sensitive to spread-oriented investments can help lower the interest rate risk of a fixed income allocation. These investments can provide a reasonable yield by shifting the risk exposure toward credit.
3) Add Foreign Exposure
You may also want to discuss shifting a portion of your clients’ fixed income allocation to international exposure. Several factors can affect global interest rates, but the economic fundamentals for individual countries are the primary drivers for their respective rates. Given the diverging global economic recovery, tactical opportunities may arise in developed and emerging international markets.
Including international exposure diversifies a portfolio away from U.S.-based interest rate risk. Accordingly, it could help dampen price volatility for your fixed income allocation in a rising rate environment. As of this writing, valuations for foreign bonds are relatively attractive compared with those of domestic counterparts.
As was the case with spread-oriented investments, this strategy involves some interest rate risk. Still, diversifying exposure to include foreign interest rate risk may help lower a portfolio’s overall volatility.
4) Employ Yield Curve Positioning
Another strategy to consider is focusing on key rate duration. This goal can be achieved by holding a diversified portfolio of fixed income investments spread across the yield curve. When looking at interest rate risk, most hypothetical scenarios envision an environment where rates shift in parallel across the yield curve.
In theory, these scenarios make for relatively simple duration calculations. In practice, however, this is rarely the case, as interest rates are affected by various factors depending on where in the yield curve a portfolio is positioned. Short-term interest rates are very sensitive to the Fed’s current monetary policy, whereas longer-term rates are driven more by the outlook for long-term economic growth. Given the variety of factors affecting rates, a diversified outlook across a fixed income allocation can help protect against nonparallel shifts in interest rates.
A portfolio invested solely in 5-year Treasury notes, for example, may see greater volatility than a diversified portfolio split between 1- and 10-year Treasury securities. This scenario would typically hold even if the portfolios have the same average level of duration. If intermediate-term rates rise while long- and short-term rates remain unchanged, the portfolio composed entirely of 5-year Treasury notes would likely see more price volatility than the diversified approach. Holding a diversified lineup of fixed income investments across the yield curve could lower the portfolio’s sensitivity to yield changes in certain segments of the market.
The Benefits of Diversification
Ultimately, the goal of a fixed income allocation is to complement other portfolio holdings that might be expected to perform relatively well in an inflationary environment. So, while acknowledging the risks of inflationary pressure, consider talking to clients about the diversification benefits and potential for downside protection that fixed income can provide to a portfolio. The prudent employment of one or some of the fixed income investment strategies described above could help mitigate the risks in the current inflationary environment.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product.
Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved. The main risks of international investing are currency fluctuations, differences in accounting methods; foreign taxation; economic, political or financial instability; lack of timely or reliable information; or unfavorable political or legal developments.