In a rising-rate environment, you need to make the most of clients’ fixed income exposure.
To help mitigate the impact of rising rates in a fixed income portfolio, you can consider a few reallocation strategies, says Vjosana Klosi, director of portfolio construction at CIBC, and author of a December 2017 research paper on fixed income and rising rates.
Before deciding on which moves to make, she considers a portfolio’s particular assets. “Not all types of fixed income react the same to rising rates,” she says. For example, longer-term and investment-grade debt are typically most affected by interest rate hikes, while shorter-duration and higher-yielding securities are more insulated, she says in her paper.
As a result, selling longer-maturity securities and investing in shorter-maturity ones can help achieve moderate duration risk in a portfolio, says Klosi. Reducing duration tends to shield overall portfolio returns, which can help investors redeploy principal and interest upon maturity—this occurs sooner with shorter-term fixed income securities, and at potentially higher interest rates.
To mitigate interest-rate risk for investment-grade debt, consider a reallocation to high-yield. Says Klosi: “Investing in higher-yielding corporate bonds or emerging market debt also brings down the sensitivity of [a] portfolio to rising rates.”
In her report, Klosi explains that higher-yielding corporate securities “are typically issued at shorter maturities to help compensate for increased credit risk.” She adds, “The impact on prices of rising yields will partially be offset by the higher coupon these bonds earn,” potentially resulting in positive overall returns.
On the downside, high-yield bears more credit risk, relative to government debt.
“When deciding on an appropriate allocation, investors should set risk targets and weigh the relative impact of higher credit risk versus lower interest-rate sensitivity in their portfolios,” says Klosi.
Get active with allocation
Beyond making portfolio-level readjustments, she recommends the use of multi-sector fixed income (MSFI) to cut down on interest-rate risk.
“This is a one-step solution where the active manager is given the discretion to allocate between various fixed-income assets with the goal of increasing the risk-adjusted returns for the portfolio, and at the same time maintaining the risk target,” she says. Duration and credit risk are managed according to changing market and interest-rate conditions.
An MSFI strategy also offers the opportunity to invest in non-traditional asset classes, such as high-yield debt, emerging market debt, asset-backed securities and bank loans. “The benchmark for these strategies is typically LIBOR-based, providing flexibility in managing overall portfolio duration and credit risk,” says Klosi in the December report.
In addition, the strategy takes advantage of diversification. “Global exposure allows for investments in countries with diverging monetary policies and lower duration risk than what we’re seeing in the U.S. and Canada,” she says.
She suggests an allocation to MSFI be made as part of the high-yield portion of a portfolio, “to take advantage of the tactical nature of these strategies versus a pure high-yield allocation.”
In a separate paper on long-term asset allocation, Klosi recommends that MSFI allocation be half as large as the typical allocation to high-yield. “Again, investors should weigh the impact of interest-rate and credit risk when deciding on a long-term asset allocation to various fixed income products,” Klosi says.
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This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.