Searching for Natural Hedges Against Interest-Rate Risk

In the United States, the fixed income story today is a cautionary tale of rising interest rates lurking around the corner. Most investors probably have heard this story for a while now, surmising that the end of the bond bull market will mean it is game over for their fixed income portfolios. Franklin Templeton’s Eric Takaha doesn’t see that as a foregone conclusion, but also believes plotting a fixed income strategy to meet tomorrow’s challenges requires a willingness to think about investing in the sector a little differently, perhaps looking beyond traditional borders, benchmarks and duration models, and seeking out strategies that have the potential to provide what could be considered a natural hedge against interest-rate risk.

Eric Takaha

Eric Takaha, CFA
Portfolio Manager, Franklin Strategic Income Fund
Senior Vice President
Director of the Corporate & High Yield Group
Franklin Templeton Fixed Income Group®

Diversifying Beyond Core Fixed Income

Do rising US interest rates mean investing in bonds or bond funds is destined to become a losing proposition? That the “bond bubble” that some say has been building for decades is set to burst? While we do not know the exact timing around future interest-rate moves, we think investors should consider managing their fixed income portfolios with a defensive posture—one that can not only potentially generate income, but also aims to position for the least-nausea-inducing ride. In our view, part and parcel of that approach should look beyond the US interest rate curve1, aiming to provide income generation and potential return across a broad range of fixed income markets globally.

We believe that in the decade ahead, the strategies that have relied on falling interest rates to generate returns could be challenged. For that reason, we think investors should think about diversifying beyond core fixed income in their portfolios—looking beyond the US rate curve to provide potential income and return across a broad range of global fixed income markets—but also be keenly focused on building and evolving a dynamic risk-management strategy.

Finding the “True Risk” in a Portfolio: An Inexact Science

We believe there is growing recognition among the investment community that risk is a primary lever in the investment process. While effective modeling is built on a foundation of transparency, no single measure—including the concepts discussed here—will provide a complete picture of the “true” risk inherent in any individual investment or portfolio. Risk professionals must look at a wide variety of data points from a host of sources and risk measures.

When discussing interest-rate risk, the conversation often turns to duration. An examination of duration (see sidebar), which takes into account bond maturity, coupon and call features, can offer a mechanism to help manage the risk—and the volatility—in fixed income investments that accompany interest-rate movements. For example, maintaining a shorter duration in a portfolio tends to result in lower interest-rate-related volatility.

We view traditional core and passive fixed income strategies with concentrated duration exposure as likely ill-suited to succeed in coming years. In our view, a truly unconstrained strategy has more flexibility to potentially navigate and exploit varying market conditions and diversify the drivers of return in a portfolio. This result becomes more apparent when compared with relatively duration-heavy core fixed income portfolios, particularly in a rising-rate environment.

Various fixed income indexes and US Treasuries have experienced relatively strong correlations (see table below), indicating that duration has been the predominant risk, and yield movements have been the primary driver of returns. Conversely, a strategy with relatively low correlation—and even a negative correlation—to US Treasuries could be a more efficient allocation to fixed income. The table below shows how cross correlations across the fixed income market can potentially enhance diversification—without guaranteeing of profits or protection against risk of loss—in an unconstrained portfolio that has the ability to exploit these different sectors.

0715_FI_CrossCorrelations

Duration and Risk: Thinking Empirically

While interest-rate movements drive a meaningful portion of fixed income returns, there are other factors, including credit spreads and currency movements, among others, that also drive returns.

One of the main risks fixed income investors are faced with is interest-rate risk—the risk that as rates rise, the value of their investments will decline. Duration is a measurement of a bond’s—or a portfolio’s—sensitivity to interest-rate movements. It measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. Generally, the higher the duration, the more the price of the bond (or the value of the portfolio) will fall as rates rise because of the inverse relationship between bond yield and price.

Example: A bond with duration of one year would lose 1% of its value if interest rates rise 100 basis points, or 1%. A bond with duration of five years would lose 5% of its value if rates rise 100 basis points. In a bond fund, that would, in theory, equate to a 1% and a 5% drop in the net asset value (NAV), respectively. Negative duration would therefore imply a gain in value if interest rates rise.

For bonds with embedded options, an option-adjusted measure of duration is used to account for changes in expected cash flows, known as option-adjusted duration (OAD).

If a rise in interest rates is anticipated, maintaining a low or negative duration might be considered to seek to avoid potential portfolio losses due to a drop in bond values. Negative duration may seem highly desirable in a rising-rate environment, but it can result in undesirable levels of volatility and risk. And, while the value of a portfolio with negative duration might increase when rates rise, there is the possibility rates may remain steady or even fall, resulting in potential loss. Our goal is to have a complete understanding of the interest-rate risk in our portfolio and position based on our views across a variety of markets and sectors. To review a portfolio’s sensitivity to interest-rate risk, we believe an examination of empirical duration—calculating duration based on historical data over a specified time period—is a worthwhile exercise.

We cannot completely remove the risk elements, but we can try to influence the interest-rate experience of a portfolio. Our approach to risk management is three-pronged: It involves recognizing the risks we are taking, making sure they are rational, and determining that there is appropriate reward potential.

In a portfolio comprising highly duration-sensitive assets, yield curve movements will dominate performance. However, there are other potential drivers of performance in a flexible, unconstrained fixed income portfolio—such as Franklin Strategic Income Fund—including various spread sector and global exposures. By expanding into these sectors, we aim to reduce the reliance on interest rates as a driver of performance. The primary performance drivers in our strategy are sector allocations and rotation decisions, along with security selection within those sectors. So, we examine empirical duration not necessarily as a primary performance driver, but as part of our overall risk-management toolkit.

Certain bonds have pricing that tends to be impacted more significantly by factors other than changes in interest rates, such as economic growth, corporate earnings patterns and temporary market shocks. This is particularly true for more credit-oriented sectors. Rising interest rates tend to accompany

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