Perspectives

Bond Strategies for Rising Interest Rates

With bond yields falling sharply since the 2008 credit crisis and remaining historically low, fixed income investors have been rewarded for venturing into longer-term, more risky sectors in an effort to boost income and returns.

However, as seen in May and June, rising rates generally result in principal declines in bonds, and that risk is exacerbated when rates are relatively low because investors have less of a yield cushion to counter losses. In those two months, for example, 10-year Treasury bonds lost 6.24%.

Investors concerned about possible further principal declines in a rising rate environment might want to explore these strategies for their fixed income portfolios.

Shorter-Term Bonds

Investors willing to accept some principal fluctuation and relatively lower yields and those with shorter time horizons such as two to three years might consider reducing their portfolio’s
maturity structure in an effort to minimize interest rate risk.

Typically, short-term bonds are less sensitive to rising rates than longer-term bonds. For example, an intermediate-term bond fund with a duration of five years would fall about 5% if rates suddenly rose by one percentage point. A bond or bond fund with a 10-year duration would decline about 10%.

(Duration measures a bond’s sensitivity to interest rates. The longer the duration, the more the principal declines as rates rise. The current duration
of the T. Rowe Price bond funds can be found on the firm’s website, troweprice.com.)

Of course, shorter-term bonds usually yield less than longer-term bonds, a factor that must be considered if the investor needs current income. Also, with current yields still low, even a modest rise in rates could result in a negative total return.

The following table shows how various bond indices have performed during prior periods of rising rates. Shorter-term bonds have withstood rising rates far better than longer-term investment-grade corporate or Treasury bonds.

While the historical record is worth noting, Mike Gitlin, T. Rowe Price’s director of fixed income, cautions it may not be a useful guide because today’s fixed income environment is “unique. We are in a once-in-a-lifetime adjustment period by the Federal Reserve. What the Fed has been doing is unprecedented, and interest rates and credit spreads are very different now than in the past.”

Higher-Yielding Sectors

Investors willing to assume more credit risk might consider high yield or below investment-grade bonds, which typically offer higher yields than investment-grade corporates and have historically performed

relatively well when rates rise.

This is because a rise in rates may reflect an improving economy, which is supportive for lower-quality debt issuers, and the higher yield can help offset principal losses.

However, junk bond yields moved up sharply in June and could still rise further, causing principal losses.

An alternative to high yield bonds are floating rate loans—also known as bank or leveraged loans—because they offer attractive yields with less interest rate risk than high yield bonds.

Such loans are typically issued by below investment-grade companies, but their duration is very short because coupons reset every three months—making them less sensitive to changes in longer-term interest rates. These loans also are higher in issuers’ capital structures and collateralized by underlying assets, which implies greater recovery rates in the event of default.

Reinvesting

Mr. Gitlin suggests that investors “review their overall portfolios to make sure they are appropriately diversified. If their exposure to fixed income has become greater than they feel comfortable with in the current environment, they might consider making modest adjustments gradually, especially if they have a lot of exposure to longer-term bonds.”

“Investors should be cautious about making any sudden shifts in their portfolios into or out of bonds, stocks, or any asset class.”

At the same time, he advises, given that investors have flooded into bonds in recent years while fleeing equities, long-term investors, investing in bonds for diversification and to reduce their equity risks, could be better off by simply looking past interest rate moves in the shorter run.

Although bonds may incur some principal erosion as rates rise, their interest payments can be reinvested at the higher yields that become available. Over time, this can be more rewarding than investing in short-term instruments that offer less volatility but lower yields.

The chart below shows the returns over time for a 10-year Treasury note with a 2.5% current yield and a 90-day Treasury bill yielding 0.25%, assuming rates for both rise by one percentage point gradually over the next year and then remain at those levels.

Rising rates initially cause a decline in principal value for the note and a negative total return, while the Treasury bill incurs no loss of principal and benefits from the rise in rates. But after a few years, the note’s loss of principal is more than offset by the additional income earned, assuming monthly coupon payments are reinvested at the higher yields.

In this example, the compound total return for both investments would be almost the same after four years. Over 10 years, however, the total return for the 10-year note would be 29.1% compared with 12.6% for the Treasury bill.

Of course, investors had to remain invested though several years of losses before the compounding of the higher yields overcame this initial setback. Also in this example, if short-term rates rose more than long-term rates, it would take longer for the note to outperform.

Companies issuing high yield bonds are not as strong financially as those with higher credit ratings, so the bonds are usually considered speculative investments. Floating rate loans are subject to significant credit, valuation, and liquidity risks. Diversification cannot assure a profit or protect against loss in a declining market.