This is the third part in a three part series on the impact of rising interest rates on our fixed income portfolios. The first article, Interest Rates Rising, Bond Prices Falling…What Now? , focuses on the basics of the relationship between fixed income investments and rising interest rates while the second article, Strategies for Bonds in a Rising Interest Rate Environment, describes some strategies that may be used if one believes interest rates will continue to rise.
This article will focus on the more common investment vehicles and which may be better in a rising interest rate environment.
First, it is important to note that there are no guarantees that interest rates will increase significantly any time soon. As I mentioned in the second part in this series, sitting in cash waiting for an increase that may or may not happen can be very costly. The amount you lose by not doing something may be greater than the amount you make by waiting.
If you don’t want to sit on a bunch of cash for years waiting on something that may or may not occur, what are your options? There are literally dozens of options, with some being much more sophisticated, that are available. I will focus in this article on the more common investment avenues if one is concerned about interest rates increasing significantly.
As a refresher from the article on strategies, one of the main differences between individual bonds and mutual funds is that individual bonds typically have a maturity date. Having a maturity date versus not, all else equal, is very important in a rising interest rate investment. If interest rates continue to rise, bond funds will be impacted by both the duration sensitivity as well as supply and demand (if there are more sellers than buyers, expectations should be that price will drop) for that particular bond fund. Since bond funds don’t have a maturity, there is no assurance, even if the credit quality remains strong, that you will get your original investment back. With an individual bond, it also will be impacted by interest rates movement and the supply and demand for that bond while you are holding it. However, if you hold it until maturity and there are no credit issues, you will receive that par amount of the bond back. Thus, there is more certainty in an individual bond portfolio versus a bond fund, assuming proper diversification.
With that in mind, individual bonds, if one can diversify, provides a more certain value at maturity than bond funds. That doesn’t mean that individual bonds are guaranteed because in most cases there is still default risk, which is why it is important to diversify. One of the main values of bond funds is the diversification. If one is working with a small amount of money, using individual bonds may not be practical.
You can also more easily ladder individual bonds as opposed to bond funds. As mentioned in the second article in this series, laddering may be very beneficial in a rising interest rate market. If I have more control using individual bonds, I am more certain there is less overlap in my laddering.
Another popular but. relatively speaking, newer option is ETP or Exchanged Traded Products. An ETP is different than a bond fund in that they are typically not actively managed but rather seek to track a specific index. Since they are not actively managed they have lower fees. Lower fees can be good but doesn’t rid you of one of the inherent weaknesses; they, like bond funds, do not have a maturity. However, since most bond ETPs are passive and try to replicate an index, you can be more effective in your laddering with ETPs versus bond funds.
Thus, when it comes to traditional bonds and if you have enough funds to diversify, individual bonds opposed to bond funds or ETPs provide better protection in a rising interest rate environment.
However, there are options other than just traditional bonds. One of those is floating rate, or bank loan, funds. I know I have spent time discussing the merits of individual bonds over funds but in the case of floating rate bonds it is difficult to find and properly diversify a portfolio of them, thus active management is important. Floating rate funds are normally only available to institutional investors. The strength of floating rate funds is they are priced with a spread over LIBOR (London Interbank Offered Rate), a short-term index rate used in corporate lending. Thus, if short-term interest rates rise, yields should be expected to rise as well. One of the weaknesses of floating rate instruments is that they are typically rated lower than investment grade, thus not suitable for all investors.
Finally, REITS (Real Estate Investment Trusts) may be an option in a rising inflation and interest rate environment (not in deflationary periods). Distributions from income producing real estate should be expected to increase in a rising inflation and interest rate environment due to rents increasing (unless inflation/costs increase faster). Compared to floating rate funds, it will be much slower of an increase because it is very dependent on how often the real estate can turn their leases. Another benefit of real estate compared to floating rate funds and bonds is the opportunity for principal growth. However, as always, risk equals rewards, which means there is also risk of a loss of principal.
These are just several areas to consider if you are concerned about rising interest rates. There are other options, some more sophisticated, to consider like BDCs, participating dividend paying life insurance, covered calls, etc. Please contact our offices if you are interested in more information.