2 ways to reduce interest rate risk

Asset prices are being influenced by monetary policy changes, with 0% interest rates currently driving returns.

So finds Peter Hardy, vice president and client portfolio manager at American Century Investments in Kansas City, Missouri. His firm manages the Renaissance U.S. Equity Income Fund.

“In May and June [2013],” he says, “the mere conversation of tapering led the [U.S.] market to sell off.” And in future, equities will be increasingly sensitive to rates hikes.

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As a result, he and his team plan to use two methods to protect clients’ portfolios.

First, they’ll look at buying businesses such as trust banks—one example is Northern Trust—that aren’t earning from their money-market businesses. Typically, they choose those that are under-earning their long-term normalized return potentials.

When rates rise, Hardy notes, trust banks should start earning money off these businesses, which means they’re positively correlated to higher rates.

Read: Position ETFs to counteract yo-yoing markets

During the market sell-off last year, he adds, trust banks posted positive returns.

Second, Hardy and his team may zero in on convertible bonds, which they identify as the securities most sensitive to interest-rate fluctuations. Buying bonds with shorter durations and avoiding high-premium convertibles helps offset portfolio risk.

When it comes to stocks, the team focus on using the bonds to reduce volatility of certain holdings. For example, they know certain technology companies tend to be unstable due to shorter product cycles.

Read: Spotlight on the tech sector

“Think about handsets,” says Hardy. “We’ve seen six different handset cycles over the last 10 to 12 years.” Using convertible bonds can help balance out clients’ exposure to factors such as tech sector trends.

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And the bonds help cut “the volatility associated with commodity price movements.” Though the oil industry is filled with quality businesses, stock prices in the space aren’t steady, says Hardy.

Read: Making money in softer markets

Smaller financial companies have capital structures that allow him to once again use convertible bonds. His team’s benchmark is nearly 30% to 35% in financial companies when it comes to their portfolio.

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For the opposite view, check out: Choose non-financial companies