The Impact of Rising Rates By: Gabriel PotterMBA, AIFA® 2015.09.03

Waiting for the shoe to drop

Since Federal Reserve Rates have been dropped to essentially zero for the past several years, fixed income investors have been antic with bated breath for the inevitable increase.  We have been preparing the foundation for the eventual rise in interest rates since the summer of 2013, both in our blog and monthly newsletter, “A Sea Change in Fixed Income”.  Since then, we’ve seen the end of Quantitative Easing in 2014, but we’ve also seen a very cautious Fed constantly defer their anticipated rate hike, time and time again. 

In January 2015, Wall Street analysts predicted the Fed would announce rate hikes at their June meeting.  Obviously, we missed that deadline because of the 1st quarter GDP slowdown.  Now, the consensus for a rate hike is for the September 16th meeting.  The question we should ask is, what are we supposed to do about this?  What do rising rates mean for institutional clients?

Low duration paper could outperform

The core traditional bond portfolio for retail and institutional investors generally follows metrics of the Barclays US Aggregate Bond index, which has an effective duration of about 5.3 years.  As a reminder, duration is a reflection of interest rate sensitivity.  High duration paper is very sensitive to changes in interest rates and low duration paper is less sensitive.  Continuing the Barclays index example, if interest rates were to move up 1%, the Barclays US Aggregate Bond index would theoretically lose 5.3% of its value.  When the Fed does increase rates, it will probably only act in 25 basis point increments (0.25%), but even a few rate hikes could negate any interest payment gains.

What can an investor do to diversify away some of this duration risk?  Low duration fixed income options including short-duration options, non-traditional bonds, or bonds less subject to changes in the US interest rates, like credit securities or currency hedged international fixed income.  A professionally managed endowment or foundation, or even a managed pension fund, may benefit from a diversified fixed income portfolio.  What about a 401(k) plan or other defined contribution plan, though?  Depending on the sophistication of an employee base, simply adding investment options in the lineup of a 401(k) plan would simply confuse most plan participants.  On the plus side, since the bulk of defined contribution assets have gravitated towards managed solutions over the past decade, like a target date series or a target-risk series, an investment committee could pay special attention to the fixed income sleeves within those all-in-one solutions and select a solution with appropriate diversification. 

A flatter yield curve

A full year ago, we were writing blog posts (“A Flatter Yield Curve”, July 28, 2014) about the probability of a flatter yield curve.  Without repeating the content in this blog post too much, the Wall Street consensus still presumes a flatter yield curve for the medium term when rates do ultimately rise.  In other words, although the floor on short term rates may ultimately move up a full percentage point or two, the longer duration paper shouldn’t move up by a proportional amount.

What does this mean for a core, intermediate duration bond investor?  In short, don’t panic.  We may be heading towards a weak environment for bonds, particularly compared to the 30 year bull market we’ve experienced.  However, for the medium term, the consensus presumes that intermediate interest rates won’t change as sharply as short rates move, thus retaining some potential value as a relatively stable portfolio diversifier, if not as an absolute return generator.

Caveats:  a baseline assumption is still an assumption

There are no guarantees in investing, so let us consider a few things that could go wrong with the aforementioned comments.  Our comments presume a world where the consensus opinion (i.e. one or two 25 basis point rate hikes in next six months) occurs without interference.  

First, as we have already pointed out, the anticipated increase in rates have not yet occurred, so eager investors who adopted a low-duration portfolio several years ago have had to endure underperformance as US traditional investments continued to advance. 

Second, the markets have largely assimilated the expectations of a rate increase.  Investors do not wait for the actual day of a rate increase to make changes, but they will reset their discounted price of interest rate sensitive bonds every day as the odds of future interest rate increases adjust.  For instance, imagine the Federal Reserve increases rates in September, but they make an unprecedented move and adjust the rate forward only 5 basis points (0.05%)  In this scenario, sharply discounted paper might actually increase in market value.  Conversely, if Fed boosts rates beyond expectations (say, 50 basis points – 0.50%), then the imputed discount on interest rate paper will be insufficient, leading to a sharp loss in market value. 

Third, the possibility of an unforeseen market event is always present.  Unforeseen events are definitely going to occur; we just don’t know if they’ll be large enough to impact base line investing scenario.  Let’s imagine a huge market event.  For example, let’s hypothesize several countries agree, in tandem, to drop the US dollar as reserve currency in exchange for the Euro and then flood the bond exchanges with unwanted US treasuries bills, bonds, and notes.  Obviously, this hypothetical market action would have a tremendous impact on bond prices and likely eclipse any trivial adjustments around interest rate hikes.

Constant vigilance

The potential for interest rate changes is going to keep prognosticators, who are trying to stay ahead of the curve, busy.  Moreover, some investment strategies, such as Liability Driven Investing plans for defined benefit plans, will require explicit recalculations every time a rate change occurs because an interest rate increase will reduce plan liabilities.  To crystallize our comments and recommendations to a single adage:  be attentive to changes and willing to adapt.    

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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