Economics

The Surprising Solutions To Managing A Rising-Rate Environment

What should bond investors do when rates are rising and the credit cycle is ending? Perhaps not what you would expect. But getting this right can be critical for the health of your fixed-income allocation.

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Knowing how to position your portfolio these days isn’t easy. Interest rates are rising, credit spreads are tight, and inflation expectations in the US and some other developed markets are rising. This has pushed US Treasury yields higher and has some economists—including ours—pricing in as many as four Fed rate hikes this year.

As we noted in a prior post, investors in these conditions often respond by reducing their duration, or interest-rate exposure, and taking on credit risk. Return-seeking credit assets such as high-yield corporate bonds tend to do well when growth accelerates and interest rates rise, while rate-sensitive government bonds struggle in those conditions.

Reducing duration modestly in the early stages of a rising-rate cycle may be appropriate, depending on a number of factors, including relative opportunities in credit, investment objectives and risk tolerance. But we’ve found that investors often tilt too far toward credit. This exposes them to credit risk at a time when asset valuations are already stretched and the credit cycle is nearing its end. It also leaves them without the diversification that interest-rate exposure provides.

Being short duration can be costly when higher rates start to put the brakes on the credit cycle and cause economic growth to slow. In those conditions, exposure to interest-rate–sensitive assets such as US Treasuries adds to returns and helps offset credit losses.

How can investors avoid falling into this trap? Here are a couple of solutions to consider:

Invest in a barbell strategy. This approach balances interest-rate and credit risk in a single strategy overseen by a single manager who can alter the weightings as valuations and conditions change. A well-constructed, well-managed barbell strategy should help to minimize risk by preventing investors from leaning too far in either direction.

Knowing when to alter the weights is as much art as science. In fact, timing an interest-rate change or credit event is difficult for even the most seasoned investors and portfolio managers. That’s why it’s important to manage credit and interest-rate risk in an integrated way. This makes it easier to monitor the interplay between interest-rate and credit risk and avoid taking on too much of either one.

Investors who segregate their rate and credit risk into separate strategies overseen by different managers are more likely, in our view, to find themselves overexposed to a single risk.

The interplay between credit and rates is always relevant. But there are times when that interplay becomes the most important risk for investors to manage. This typically happens when a central bank’s attempt to slow a credit cycle is the key factor driving interest rates and bond yields higher. To us, that’s a good description of where we are today.

Might lengthening duration as rates rise lead to short-term losses? Sure. But if your investment horizon is longer than a few months, that shouldn’t matter. Over time, higher yields mean higher returns—for both interest-rate–sensitive and credit assets. Over the medium term, US Treasury returns come mostly from the yield. That means rising rates can boost income for investors who are not primarily focused on short-term price fluctuations.

For instance, the yield on the 10-year US Treasury note has nearly doubled since mid-2016, and at roughly 2.9% puts the benchmark note closer to what we consider fair value than it’s been in years. That makes it a valuable income generator and a hedge against high-yield corporate bonds, which still look expensive relative to history.

That’s not the case in Europe, where benchmark German Bunds look expensive, suggesting yields have further to rise than in the US. This is why it’s important to think globally when deciding where to take risk.

High-quality interest-rate exposure can also keep your bond portfolio liquid, allowing investors to rebalance their portfolios in the future by selling outperforming government bonds and buying underperforming credit assets at discount prices.

Diversify your credit exposure. At this stage in the credit cycle, investors should resist the urge to reach for yield, and instead concentrate on maximizing opportunity and reducing risk. Even investors who opt to dial down their credit risk will need some exposure to credit to provide income and maintain portfolio balance.

But the type of credit matters. A global, multi-sector strategy can provide access to multiple sources of income and return and help prevent investors from overconcentrating in any one sector.

For instance, we see value in US securitized assets, select emerging-market debt and subordinated European financial bonds, which offer attractive yields to compensate investors for the risk they take by buying a bond further down the capital structure.

US and European high yield, on the other hand, are in the later stages of the credit cycle and look expensive. That doesn’t mean investors need to avoid them entirely. But they do need to be cautious and selective.

What not to do? Don’t replace your high-income strategy with a portfolio of leveraged bank loans in hopes that bank loans will protect you against rising rates. Bank loans have failed to meet those expectations.

We think taking these steps can help investors avoid some of the more common mistakes people make when markets near an inflection point and cycles turn.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by Douglas J. Peebles, Alliance Bernstein