Today’s historically low interest rates can not last forever.  Two important factors will eventually affect the Fed’s decision to raise rates: inflation and the overall health of the economy. When inflation is too high or increasing too rapidly, the Fed may raise rates in order to slow the economy and trim inflation.

As interest rates rise, there can be a significant negative effect on the value of fixed-income investments because interest rates and bond prices move in opposite directions – in other words, as interest rates move up, bond prices can fall in value.

Now May be a Good Time to Re-examine Your Bond Portfolio

Several factors can cause the price of a fixed-income security to change.  They include a change in interest rates, a change in credit quality and/or a change in secondary market liquidity for bonds (demand).

Market forces work to align bond prices with prevailing interest rates.  Generally speaking, if interest rates move higher, bond prices fall since investors can purchase new issues with higher coupons.  The opposite occurs as interest rates fall and new issues offer lower coupons.  When this happens, investors are willing to pay higher prices for comparable fixed-income investments that have higher coupons.

Several Forces can Move Interest Rates:

• Supply and Demand.  During times when investors are looking to take less risk, there is often a strong demand for US government-backed fixed-income investments.  As more investors look to purchase Treasury bonds, yields drop while prices rise.  Supply can also have a significant effect on interest rates.  As companies or governments issue more bonds, the supply of bonds in the market place increases, moving yields higher and prices lower.
• Economic Growth.   Interest rates are influenced by changes in the long-term outlook for the economy.  As economic conditions improve, investors anticipate that higher interest rates may be needed to “cool off” the economy and keep inflation under control.
• Inflation outlook.  Inflation, the upward trend of prices over time, can have a significant impact on fixed-income investments.  If inflation is greater than anticipated over an investment horizon, it will be difficult to maintain assets’ “purchasing power.”  As inflation increases, interest rates tend to rise.
• Monetary policy.  The Federal Reserve uses monetary policy to control the money supply in the economy.  The fed funds target rate is the most visible tool and directly impacts short-term yields.
• Fiscal policy.  The government budgetary process contains two main instruments: expenditures and taxes.  How the president and legislature manage the process can have a meaningful impact on interest rates.  Governments often use fiscal policy to impact economic performance, and they typically increase spending during times of economic duress (i.e. look at government spending since the meltdown in 2008) and scale back spending as things improve.  Over a multiyear time horizon, excessive spending can increase the supply of government debt and lead to a “crowding out effect” as investors require higher yields to fund the increasing supply of debt.
• Risk yes/no.  During times of economic or political uncertainty, risky assets tend to fall in value as investors favor lower-risk alternatives.  In spite of the US debt and deficit issues, Treasury securities remain the asset of choice for investors in search of perceived safe havens.  The increased demand general move interest rates lower and prices higher.

The Importance of Duration

It is important for fixed-income investors to understand duration and how they can use the calculation to gauge interest-rate risk and the approximate impact that rising rates may have on fixed-income investments.  Duration measures the sensitivity of a bond’s price to a change in interest rates.  The duration calculation can be used by investors to approximate the percentage change in price per 1% parallel shift in the yield curve.  For example, the price of a bond with a duration of five years would be expected to rise or fall 5% in price for every 1% decrease or increase in market interest rates.  The longer (higher) the duration, the more prices will fluctuate as interest rates rise and fall.  Long-term bonds tend to have longer durations, and their prices can fall quickly when interest rates are on the rise.

Using duration to estimate the impact of rising interest rates

In the table below, you can see the duration and price performance of three generic bonds.  The coupon levels (yields) are based on an upward-sloping interest-rate curve.  We show the impact on each bond’s price in three different interest-rate scenarios.

*Market value after instantaneous increase in the yield curve.  Examples are used for illustrative purposes only and do not reflect the rates for any investments available for purchase through South Coast Investment Advisors.

For investors concerned that a period of rising rates is imminent, it may be prudent to shorten duration by redeploying investments to shorter durations.  As seen in the table, longer maturity securities typically underperform when rates rise.

Strategies for fixed-income investors

At South Coast we utilize several strategies in order to protect our clients:

• Diversification.  It is important to not only diversify amongst asset classes, but also by duration and strategy.
• Hard Assets.  At South Coast we like assets that benefit from inflation and rising rates such as real estate, energy, and equipment leasing.  By allocating a portion of a portfolio to these types of asset classes we can further hedge against inflation and rising rates should they come to fruition.
• Tax Advantaged Investing.  It’s not what you make, but what you keep.  By utilizing tax advantaged investments in a portfolio, we are often able to take less risk for the same net return giving our clients a preferable risk-adjusted rate of return.

It is important as an investor to realize what kind of environment we are in and which investments and strategies work best in those environments.  What has been working for the last 20 years may not work for the next 20.  If you would like a complimentary portfolio review to see if your portfolio is properly positioned, call the South Coast Office.

– Posted by Chris