Today, inflation is the highest we have seen since the 1980s. With peaks of 7% inflation in 2021, it hit a 30 year high in the U.S., leading to a shift in Fed Policy form “transitory” inflation. A rising rate environment has significant impact on investments. Choosing bonds to beat rising inflation can help you to maintain portfolio stability.
For most, bonds will always play an important role in balancing the portfolio. Even in a rising-rate environment, bonds provide stability or ballast against a volatile stock market. However, you want to make sure you manage the duration (measure of rate sensitivity) in your bond slice of the pie.
Why Do Bond Prices Decline as Interest Rates Rise?
Bonds are issued as loans to corporate and government entities, basically as an IOU to the investor. They’re also issues with a rate, normally somewhere around 5%. If interest or inflation rise faster than that rate, holding it to the maturity date may not result in profit. In addition, as interest rates rise, new bonds are issued with a higher rate. Therefore, selling off old bonds with a lower rate won’t happen unless they’re issued with a discount. This means bonds and bond mutual funds are subject to market volatility.
Floating Rate
Floating rate bonds use variable interest payments which change according to the interest rate market and typically are low duration. This can largely protect you from fluctuating and rising interest rates. However, floating rates have some downsides as well. For example, they typically offer lower yields. and they increase your credit exposure.
Why? They normally have short maturities to protect the issuer from fluctuating interest rates. Therefore, changes in interest rates have significantly limited impact on the value. So, you’ll take on less interstate risk.
Collateralized Loan Obligation
Collateralized Loan Obligations (CLOs) are securities backed by debt, usually to corporates with low credit ratings or to private equity firms. The priority of payback is high, but investors also assume most of the risk if the debtor defaults. These offer higher than average returns, which is often not greatly reliant on interest rates – but with higher risk taken on by the investor. Debt Tranches for example offer a specific stream of interest and payments, similar to corporate bonds. Equity tranches can be higher risk and more impacted by interest and inflation, because they rely on the eventual value of the CLO if it is sold in the future.
Low Duration Bonds
Low duration or short-term bonds shorten the period in which rising rates can have an impact on value. For example, if you have a 10-year bond and interest rates rise an average of 1%, you could lose 10% of the bond’s value. Here, you’ll also have to choose between Treasury bonds and Corporate Bonds. Both carry different kinds of risk. For example, treasury bonds are only impacted by interest rate risk and not credit risk (AAA). Short-term corporate bonds are affected less by both credit and interest risk.
Hedging Rate Risk
Hedged bond strategies use investment grade or high-yield bonds with built-in hedges. These are intended to alleviate rising treasury rates. However, you’re still exposed to credit risk. However, this strategy allows you to diversify into 30-year Treasury bonds, which will always have a higher return than shorter bonds or notes. Hedged rates specifically aim to reduce rising rate risks without impacting credit risks which could impact returns.
Diversification is Key
While any of the strategies above can help to protect your portfolio from rising interest rates, all incur some additional risk. Therefore, the optimum strategy is still to diversify as much as possible, with hedging, low duration, CLO, and floating rate bonds. You may also consider Treasury-Inflation-Protected Securities (TIPS) as an alternative – as these are backed by the FED. Your best option is to have a discussion with your asset manager to discuss how best to diversify your portfolio for specific, predicted interest rates
Key Takeaways
- Short- and medium-term bonds are less exposed to risks. However, they also have lower returns
- Hedged bonds can offer security against rising interest rates but may perform poorly if rate increases moderate or stop
- Floating rate bonds reduce the impact of interest rates by moving with the Fed. However, they also lower return. Most are also short-term bonds to protect the issuer
- CLOs and TIPS can provide extra security in case of rising interest rates.
Interest rates are likely going up and significantly for the first time since pre-2007-2009. That’s important for investors, who might see significant decreases in returns from long-term bonds. Hedging against those losses is important, especially for the mid-to-short-term. If you need help assessing or diversifying your portfolio with a hedging strategy based on your portfolio and risk, Tangent Retirement can help. Contact us for a consultation or discussion to get started.
This information is for reference only and should be reviewed with a qualified professional as you situation may vary from others. Nothing mentioned above is a guarantee nor should this be considered advice.
Golden State does not and cannot deliver tax advice and the material herein is for information only. Please consult a qualified tax professional for opinions related to your particular situation.
Investment advisory services are offered through Golden State Equity Partners, LLC, an investment adviser registered with the U.S. Securities and Exchange Commission. Tangent Retirement is a DBA of Golden State Equity Partners, LLC.
