By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: December 14, 2010
Fixed income investors face a challenging environment as yields continue to move higher and drive down bond prices. Since hitting a low of 2.38 percent on Oct. 11, the yield on the 10-year U.S. Treasury Note has advanced more than 80 basis points, which is a very pronounced rise in a short period of time. With equity funds having experienced over $300 billion in net outflows and bond funds having attracted more than $400 billion in net inflows this year, many investors have significantly increased exposure to interest rate risk. You may wonder how financial planning practitioners effectively manage interest rate risk, and what steps can be taken to reduce the downside of rising rates for your bond portfolio.
Rising interest rates are, by definition, the enemy of bonds. One of the easiest ways to manage interest rate risk in a bond portfolio is to limit the duration of your bond holdings. A lot of people confuse duration with maturity. Maturity only measures the term of a bond while duration is a measure of how sensitive a bond or a bond portfolio is to changes in interest rates. The actual calculation for duration is fairly complicated, but there is a rule of thumb that if the duration of a bond portfolio is multiplied by the change in market interest rates you should get a good estimate of how much bonds will change in price. For example, a bond portfolio with an average duration of five would experience a price decline of 5 percent if market interest rates moved higher by 100 basis points. So, by limiting the duration of your bond holdings, you can limit interest rate risk.
Opting for a lower duration bond portfolio typically means that you are forced to accept lower yields. Income-oriented investors, however, are not limited to the bond market, because floating rate funds can offer exposure to a new asset class without the interest rate risk of bonds. These funds primarily hold portfolios of bank loans with interest rates that are pegged to market interest rates. Since interest rates on bank loans rise with increases in market interest rates, bank loan portfolios do not lose value like fixed rate bond portfolios. Interest rates for bank loans are often based on the London Interbank Offering Rate, or Libor. Currently bank loan spreads are approximately 4.5 percentage points above Libor, meaning that yields of up to 6 percent can be obtained by investors.
Floating rate funds, however, come with their own risks. Most of these funds concentrate on loans to companies that have lower credit ratings; many have credit ratings that average “B” or “BB.” It is important to recognize that by moving some capital from bonds to floating rate funds, credit risk is, to a certain extent, replacing interest rate risk. Nevertheless, in the event of a default, bank loans actually have a much higher recovery rate than bonds. Loans had a 62 percent recovery rate in 2008, while bonds had a 34 percent recovery rate that same year. Bank loans are also not immune from market turmoil, as floating rate funds lost an average of 27 percent in 2008.
The overall trend in corporate profits, however, does bode relatively well for less creditworthy borrowers because they are affected more by changes in economic conditions. In addition, an extension of tax cuts will reduce the chance of a “double dip” recession, so investors considering an allocation to lower credit quality investments may have macroeconomic conditions working in their favor.
Ultimately, you need to ask yourself if taking on more credit risk is worth the reduction in interest rate risk that comes with moving money from bonds to floating rate funds. For investors with portfolios of very high quality corporate and government bonds, the diversification benefits associated with floating rate funds may outweigh the additional credit risk. On the other hand, if you already have a significant allocation to high yield bonds and other lower rated debt, too large an allocation to floating rate funds could create too much credit risk in a portfolio. As such, it is important to consider the different segments of the bond market that you already have exposure to before contemplating an investment in floating rate funds. Do you already have exposure to some segments of the bond market that can hold up better than others when rates rise? Is your bond portfolio well diversified? Do you have allocations to foreign bonds and Treasury Inflation Protected Securities? Could limiting the duration of your holdings eliminate enough interest rate risk while maintaining an acceptable yield? If you are not familiar with balancing yield and different types of risk (interest rate, credit and inflation risk,) you should consider consulting with a financial planner who can construct a portfolio that is consistent with your risk tolerance and investment objectives.
FPA member David Zuckerman, CFP®, CIMA®, is a fee-based financial planner and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif. He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.