You are probably hearing a lot in the news about the Federal Reserve’s Quantitative Easing (QE) program and its potential slowdown (referred to as “tapering” by the press). The QE program increases the demand for long-term bonds, thus driving their prices upward, and lowering long-term rates. Investor expectations that the program may be ending sooner than expected have been driving the increased volatility of interest rates and bond prices as of late.

As you know, bond prices move down when interest rates rise. This happens because bonds pay investors a fixed interest rate or yield, and therefore existing bonds become less attractive as prevailing interest rates go up. Investors therefore prefer these more attractive bonds, which forces prices of existing bonds down until rates equalize.

As the Federal Reserve winds down its accommodative stance, we expect that rates will gradually return to “normal” levels. This generally means that short-term rates (for maturities of one year or less) may be running at or slightly above the rate of inflation, and longer-term rates (for maturities of 7-10 years) may be running at a rate equivalent to inflation plus the rate of current GDP growth. For example, an inflation expectation of 2% and GDP growth of 2.5% per year will imply short-term rates close to or just above 2% and long-term rates close to or just above 4.5%.

As an investor, you may note that this type of move will mean a 1% to 2% increase in rates from more recent levels. If this move were to happen immediately, it may cause a sharp decline in bond prices; however, we do not expect that this large of a change will happen overnight. It is more likely that long-term rates will start to gradually move up, first as QE starts to be wound down and then ends. The shorter end of rates is then likely to also rise as the Fed gradually ratchets up the Federal Funds rate (a key determinant of short-term rates, currently set at 0.0%-0.25%) in or after 2015.

Despite concerns about flat to negative market returns in fixed income, we believe that bonds deserve an allocation in investors’ portfolios even in a period of rising rates. However, as an investor you may want to protect your fixed income holdings from some of the possible price volatility in bonds. To position portfolios in anticipation of a rate rise, investors may want to consider one or a combination of the following strategies:

• Lower portfolio duration — investments with lower duration are less sensitive to movements in rates, therefore, lowering portfolio duration may help investors to also lower interest rate risk. These investments include:
  • Ultra-short bond funds
  • Short-term bond funds
  • Intermediate bond funds which have positioned themselves shorter than benchmark
• Focus on floating rate bonds — Floating rate fixed income securities offer a yield which varies based on the current rate or price of an underlying index. In a period of rising rates, such securities may not decrease in value, or their prices may actually increase as more investors focus on the asset category. Investments in this category are Floating Rate High Income (also known as Bank Loan) funds.
• Increase allocation to credit sensitive investments — Bond categories trading at a risk premium/spread over Treasuries may provide some protection from rising Treasury rates, as spread compression often occurs in a rising economy, which may offset some of the Treasury rate increase. This happens because as the economy improves, bond issuing companies have increasing sales and higher cash flows, and are therefore more likely to repay bonds in full. Investors then demand a lower risk premium/spread as protection against default, and spreads contract, a trend known as “spread compression.” Spread compression acts like a rate decrease and is positive for credit-sensitive bonds, which may help in a period of rising rates. These investments include:
  • Domestic Corporate/Credit bond finds
  • High Yield bond funds
  • International bond funds
• Consider alternative investments — Investors may want to diversify a small portion of a portfolio’s fixed income assets to absolute return investment strategies (alternative investments) that have similar risk profiles to fixed income. These strategies have low correlation to bond returns and may continue to provide a good yield in times when rates increase, but their lower correlation means that they will likely mitigate some of the return volatility as compared to an all bond portfolio. Strategies like this include:
  • Equity Market Neutral
  • Equity Long/Short
  • Managed Futures
• Consider equities — A modest overweight to equities may also be warranted for investors with a longer time horizon.

As always, we recommend that investors see their financial advisors for recommendations in these asset classes.