Rising Interest Rates: The Good, the Bad…No Ugly

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Rising Interest Rates: The Good, the Bad…No Ugly by Douglas J. Peebles, AllianceBernstein

The US Fed has said it will almost certainly boost short-term interest rates by 2015, and many bond investors are focused intently on managing the risks of rising interest rates. But it’s also important to recognize that there are benefits.

By their nature, bonds are generally sensitive to interest-rate movements—when rates rise, prices typically fall. With short-term rates on the way up, other interest rates won’t stay low forever, either. But across all bond sectors, from high grade to high yield, rising rates can have positive effects. We believe investors should see a rise in rates as, ultimately, a good thing for bond portfolios. (And by ultimately, we mean just a few years.)

The Value of Higher Yields…and Time

Most investors can be relatively comfortable investing with a five-year horizon. You’ll face some emotional challenges, especially when markets are volatile (and short-term volatility is almost a given with higher-yielding bonds), but if you can sit tight for a few years, history suggests your bond investments can gain even if rates rise.

We’ll present two simple scenarios to show how this works.

Let’s say you own a portfolio of bonds spread across maturities from one to five years, with an average yield of just over 3% and an average duration (or interest-rate risk) of just under three years. Given the level of US Treasury yields today, this portfolio would include high-yield investments. In the first scenario, interest rates don’t change and you earn a little more than 3% over a five-year time period (Display, blue line).

In the second scenario, you also earn a 3% yield at the outset, but the very next day interest rates rise by 1.25% (125 basis points) and remain at that level for the five-year investment horizon (Display, green line). This yield increase causes an initial price loss of about 3.4%—certainly a painful experience. However, the loss is eventually offset by a higher growth path.

What’s the source of this higher growth? First, as you reinvest the coupon income that your portfolio pays, you’ll be able to reinvest it at higher yields. Income matters: for investors who use bonds to generate income, rising rates change from a threat to an opportunity. Second, as the bonds in your portfolio mature, their price pulls back to par, and you can reinvest their principal value in newer, higher-yielding bonds.

This puts your total return on a higher trajectory than in the first scenario. After less than a year, the portfolio’s value is back to its starting point. By the third year, the portfolio has not only caught up to where it would have been had interest rates never risen, but it’s continuing to grow at this higher rate. This break-even point, where the two lines cross, is equal to the duration of the portfolio—regardless of how large the rate rise. From that point forward (about three years in our example), you’ll likely be better off thanks to higher rates.

In fact, you could say that as long as the duration of your fixed-income portfolio is shorter than the amount of time you’re investing, rising interest rates can boost your total returns.

(Institutional investors employing liability-driven investing use a similar strategy: they buy long-duration bonds so they don’t have to worry about whether interest rates are rising or falling as they fund future obligations such as employee retirements. The longer bonds allow them to match the duration of their bond portfolios to their longer investment horizons.)

A Couple of Caveats

What if an investor says, “I’ll just wait until yields rise”? That’s fine if you think you can guess when yields are going to rise and when they’ll hit their peak, but given that cash is yielding 0%, that’s a very expensive guessing game to play today. And if you need income, it’s not wise to let your assets sit too long in cash.

There are risks that can impact some of our scenarios. For higher-yielding portfolios, investing in high-yield securities—where defaults are a possibility—will be necessary. Any default will reduce returns in either scenario, so stretching for even higher-yielding CCC-rated bonds may prove costly. In our view, for more conservative portfolios, it’s best to stick with BB-rated and B-rated bonds that offer some yield above investment-grade issuers, but considerably less credit risk than CCC-rated bonds.

What if an investor isn’t reinvesting income, but spending it? As long as the rate of spending in our two scenarios is equal, the break-even point is the same, since spending reduces the returns of both scenarios.

Let Time Do Its Work

In our view, investors with a multiyear investment horizon can feel fairly confident that all but their longest bond investments will be worth more at the end of their investment horizon than they are today. And, if that investment horizon exceeds the duration of their investments, rising interest rates may actually benefit investors’ bonds over time. The challenge is to be patient enough to let time work to your advantage.

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

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income and Ivan Rudolph-Shabinsky is a Portfolio Manager of Credit, both at AllianceBernstein Holding LP (NYSE:AB).

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