In our view, returns experienced during the “taper tantrum” represent a possible best-case scenario for traditional rising-rate strategies. Over that time, longer-term interest rates rose while short-term rates remained contained, helping to insulate investors from losses that reduced interest rate risk. When the market becomes more concerned about the timing of the first Fed rate hike, this portion of the yield curve, where investors formerly sought safety, could come under considerable pressure. At current income levels, the margin for error remains extremely low.
As an alternate approach, we also illustrate how a duration-hedged approach performed since the Fed began tapering. In this strategy, Barclays Rate Hedged U.S. Aggregate Zero Duration Index is exactly the same as the traditional Barclays U.S. Aggregate Index, but a second-step adjustment seeks to hedge interest rate risk to zero. As a result, investors were able to maintain traditional bond exposures while reducing interest rate risk. With hindsight, we know that hedging interest rate risk detracted from returns as rates fell during Fed tapering. However, when compared with traditional rising rate alternatives, this approach, demonstrated by the Barclays Rate Hedged U.S. Aggregate Zero Duration Index generated significantly better performance. In subsequent blog posts in this series, we will discuss similar approaches to managing interest rate risk in greater detail.
Ultimately, the timing of changes in Fed policy remains far from certain. However, with Fed tapering largely a foregone conclusion, investors should begin to prepare their portfolios for the next move in Fed policy.
Important Risks Related to this Article
Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.