LPL Financial Researchers Weigh In on Managing Interest Rate Risk

As 2017 ended, fixed income investors were searching for income, after several years of 10-year Treasuries yielding less than 2.5%, according to John Lynch, chief Investment strategist, LPL Financial, and Colin Allen, assistant vice president, LPL Financial.

In an LPL research report, they note that when 2018 began, this changed quickly as tax reform and signs of inflationary pressures pushed market interest rates higher. The 10-year Treasury yield rose 0.87%, from a starting yield of 2.04% on September 7, 2017, to 2.91% on February 15, 2018. Investors have grown concerned that improving economic data and rising inflationary pressures may cause the Federal Reserve (Fed) to raise interest rates in 2018 at a more aggressive pace than originally anticipated. Given this backdrop, investors are naturally reassessing their interest rate risk.

The researchers expect yields to grind gradually higher during the year, but not in a straight line. As such, they continue to recommend portfolio positioning with a duration (a measure of interest rate sensitivity) lower than the Bloomberg Barclays U.S. Aggregate Index, along with additional diversification across sectors, maturities, and credit ratings (for suitable investors), which may potentially help mitigate the impact of rising interest rates on investors’ portfolios.

A sector comparison of broad market returns can be can be used to determine relative outperformance or underperformance against the Bloomberg Barclays Aggregate. The data shows the difference between credit risk and interest rate risk is a meaningful one of which investors should be keenly aware, according to the research article. U.S. Treasuries have the least credit risk, as they are backed by the full faith and credit of the U.S. government. They carry elevated interest rate risk, however, as their price sensitivity to interest rate changes (duration) is higher than the broad Bloomberg Barclays Aggregate. This explains Treasuries’ underperformance in most of the rising rate periods. High-yield bonds, conversely, possess higher credit risk and lower interest rate risk. Generally, interest rates rise when economic growth and inflation pick up, a scenario that’s usually a good backdrop for economically sensitive portions of fixed income, like high yield. The additional yield cushion is also a buffer against higher interest rates that could push prices lower. Despite this, the researchers still believe lower-quality fixed income should be used at the margins of higher quality, for suitable investors.

According to the researchers, sector diversification and yield curve positioning can help investors during rising-rate periods. Investment-grade corporate bonds possess greater interest rate sensitivity than the broad high-quality market, because of their longer maturities. The researchers favor the intermediate portion of the yield curve, which boasts diversification benefits without the significant interest rate risk of long-term bonds. By either targeting intermediate-maturity corporate bonds directly, or using an active investment manager to position the portfolio opportunistically, investors can manage the headwinds of rising rates on investment-grade corporates.

The researchers add that high-quality mortgage-backed securities (MBS) have performed well in most rising interest rate environments.

Even though bond prices fall as interest rates rise, and interest rates have risen notably since the beginning of the year, investors should remain focused on their long-term objectives, the researchers warn. By focusing on total return rather than on short-term market price fluctuations, investors can avoid selling at inopportune moments due to emotion. Total return is the rate of return over time that is derived from interest income, plus gains or losses on the price of the bond. As interest rates rise, the cash flows of the bond will eventually be reinvested at higher prevailing interest rates. Over a longer horizon, the investor may chip away, or even overcome, price declines that occurred due to rising interest rates. “The takeaway is critical: it pays to remain patient,” the researchers wrote.