Rising rates are destructive to bond investors due to the inverse relationship between prices and yields. When rates go up, prices go down – and in some cases, the move can be dramatic. As a result, fixed-income investors often try to diversify their portfolio with an allocation to asset classes that can perform well even when rates are rising.
Bond Interest Rate Sensitivity
First, let’s consider some of the conditions that typically lead to higher rates:
Stronger economic growth
Growing expectations that the Federal Reserve will raise short-term rates at some point in the future
Elevated risk appetites, which prompt investors to sell lower-risk fixed-income investments (which drives rates up, and prices down) and buy higher-risk bonds (which drives rates down and prices up).
With that in mind, here are six different investments to consider when looking for protection when any of the above conditions fuels rising rates:
Unlike a plain-vanilla bond, which pays a fixed rate of interest, a floating-rate bond has a variable rate that resets periodically. The advantage of floating-rate bonds, compared to traditional bonds, is that interest-rate risk is largely removed from the equation. While an owner of a fixed-rate bond can suffer if prevailing interest rates rise, floating rate notes can pay higher yields if prevailing rates go up. As a result, they tend to perform better than traditional bonds when interest rates are rising.
Short-term bonds don’t offer the same yields as their longer-term counterparts, but they also provide more safety when rates start going up. Although even short-term issues can be impacted by rising rates, the impact is much more muted than it is with longer-term bonds.
There are two reasons for this: 1) the time until maturity is short enough that the odds of a substantial increase in rates during the life of the bond are lower, and 2) short-term bonds have a lower duration, or interest rate sensitivity than longer-term debt.
As a result, an allocation to short-term debt can help reduce the impact that rising rates can have on your overall portfolio.
High Yield Bonds
High-yield bonds are on the riskier end of the fixed income spectrum, so it’s somewhat counterintuitive that they could outperform during periods of rising rates. However, the primary risk with high yield is credit risk, or the chance that the issuer may default. High yield bonds, as a group, can actually hold up well when rates are rising because they tend to have a lower duration (again, less interest rate sensitivity) than other types of bonds with similar maturities. Also, their yields are often high enough that a change in prevailing rates doesn’t take as large of a bite out of their yield advantage over Treasuries as it would a bond with a lower yield.
Since credit risk is the primary driver of high yield bonds’ performance, the asset class tends to benefit from an improving economy. This isn’t true for all areas of the bond market since stronger growth is often accompanied by higher rates. As a result, an environment of faster growth can help high yield even as it hurts Treasuries or other rate-sensitive areas of the market.
Emerging Market Bonds
Like high-yield bonds, emerging market issues are more credit-sensitive than they are rate sensitive. Here, investors tend to look more at the underlying fiscal strength of the issuing country than they do the prevailing level of rates. As a result, improving global growth can – but certainly not always – be positive for emerging markets debt even though it typically leads to higher rates in the developed markets.
A prime example of this was the first quarter of 2012. A string of better-than-expected economic data in the United States fueled investor risk appetites, driving rates higher and causing the largest exchange-traded fund (ETF) that invests in U.S. Treasuries – the iShares Trust Barclays 20+ Year Treasury Bond ETF – to return -5.62%. At the same time, however, the growth outlook sparked a surge in investor risk appetites and helped the iShares JPMorgan USD Emerging Markets Bond Fund ETF produce a positive return of 4.47%, a full ten percentage points better than TLT.
The divergence is unlikely to be this substantial most of the time, but this nonetheless provides an idea of how emerging market debt may help offset the impact of rising rates.
Convertible bonds, which are issued by corporations, can be converted to shares of the issuing company’s stock at the bondholder’s discretion. Since this makes convertible bonds more sensitive to stock market movements than a typical plain-vanilla bond, there is a greater likelihood that they can rise in prices when the overall bond market is under pressure from rising rates. According to a 2010 Wall Street Journal article, the Merrill Lynch Convertible-Bond Index rose 18.1% from May 2003 through May 2004 even though Treasuries lost about 0.5%, and it rose 40.5% from September 1998 through January 2000 even as Treasuries lost nearly 2%.
Inverse Bond Funds
Investors have a wide range of vehicles to actually bet against the bond market through ETFs and exchange-traded notes (ETNs) that move in the opposite direction of the underlying security. In other words, the value of an inverse bond ETF rises when the bond market falls, and vice versa. Investors also have the option to invest in double-inverse and even triple-inverse bond ETFs, which are intended to provide daily moves that are two or three times the opposite direction of their underlying index, respectively.
There is a wide range of options that enable investors to capitalize on downturns in U.S. Treasuries of different maturities as well as different segments of the market (such as high-yield bonds or investment-grade corporate bonds.
While these exchange-traded products provide options for sophisticated traders, the majority of fixed-income investors need to be extremely careful with inverse products. Losses can mount quickly, and they don’t track their underlying indices well over extended time periods. Further, an incorrect bet can offset gains in the rest of your fixed income portfolio – thereby defeating your long-term goal. So be aware that these exist, but be sure you know what you’re getting into before you invest.
What to Avoid If Rates Rise
The worst performers in a rising-rate environment are likely to be longer-term bonds, especially among Treasuries, Treasury Inflation-Protected Securities, corporate bonds, and municipal bonds. “Bond substitutes” such as dividend-paying stocks, can also suffer meaningful losses in a rising-rate environment.
The Bottom Line
Timing any market is difficult, and timing the direction of interest rate movements is next to impossible for most investors. As a result, consider the options above as vehicles for maximizing portfolio diversification. Over time, a well-diversified portfolio can help you raise your odds of outperforming across the full range of interest rate scenarios.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Talk to a financial advisor and tax professional before you invest.