With the ultra low interest rate environment becoming more of a norm in many investors’ mind, complacency has driven portfolio managers to maintain the status quo and stick to traditional duration and asset allocation targets. Recent history of bond market behavior has also supported this view. On a forward looking basis, however, the important questions center around how risk/return profiles change under rising interest rate environments and what investors should consider in evaluating the risk of their current portfolio mix.
From a macro perspective,most investors would agree that given low yield levels in the current marketplace, the balance between upside and downside in bond yields is quite asymmetric when viewed over a long investment horizon. The absolute low yield levels (0.5% on the 2-year Treasury, 2.6% on the 10-year Treasury) imply that there is much more downside in price (upside in yield) versus additional upside. It is the reverse of the early 1980’s when Treasury yields reached levels in the mid-teens.
Another important factor to consider in the current environment is the narrow spread levels prevalent in the credit markets. The ample liquidity provided by the Fed coupled with the dramatic improvement in credit risk have contributed to continued narrowing of credit spreads to near the tight end of the range the market witnessed just before the credit crisis started in 2007. This bullish credit sentiment can be seen in most liquid credit products in the U.S. bond markets including corporate bonds, MBS, CMBS and ABS. The relevance of this observation is that, typically, there is a high tendency for spread levels to widen significantly in a bond market sell-off, especially if the sell-off is rapid and the market is coming out of an environment of narrow credit spreads.
Given this current backdrop, we believe there are excessive risks associated with many bond portfolios if the markets were to go through a period of rising interest rates, whether it is gradual or rapid. The major risks can be quantified and decomposed as follows. The primary risk is interest rate duration followed by the risk of widening credit spreads. As an illustration, in a scenario where interest rates rise by 50 basis points, a 10-year duration corporate bond portfolio would suffer a 5% loss due to the rate duration effect alone. Furthermore, if corporate credit spreads were to widen by 25 basis points under this scenario, there would be an additional loss of 2.5%. Another factor to keep in mind is the low coupon/yield levels which provide limited cushion against a mark-to-market loss as rates rise. In the example above, a 10-year duration corporate bond portfolio with a 5% average coupon will only be able to generate enough income to offset a mark to market loss if rates were to rise by less than 50 basis points over a one-year period. In a higher rate (and arguably more normal) environment that many investors are more accustomed to, the break-even rate rise that causes a loss on a total return basis would be greater.
Below we summarize a number of rising rates strategies that have either been discussed or implemented in the marketplace. We have highlighted some of the pros and cons of these strategies that are designed to protect portfolios against rising rates.
Hedged Aggregate Bond Index Strategy
This type of strategy provides broad exposure to different sectors of the bond market while over-hedging the duration risk. For example, the “Barclays Rate Hedged US Aggregate Bond Index, Negative Five Duration” over-hedges the US Aggregate Bond Index with enough Treasuries to attain a net duration of negative five years. While this type of exposure can potentially achieve neutral carry as the positive yield from the credit exposure offsets Treasury hedging costs, the index is highly exposed to spread widening under a rising rate environment.