Managing Risk in a Rising Interest Rate Environment

Assets invested more conservatively to avoid stock market risk must still provide a reasonable contribution to portfolio return. This is currently complicated due to the risk of bonds falling in value in a rising interest rate environment.

However, the bond market is not homogeneous. Bond investments can vary in the degree to which their values are impacted by changes in interest rates. We want our clients to have a blend of fixed income investments to manage interest rate risk and achieve a competitive return. The following is a brief description of a few options we use in an effort to achieve those goals.

Conventional Bond Funds

Generally, the shorter the time to maturity, the less a bond will decrease in value as rates rise. In the current interest rate environment, we think a mix of bonds with different maturities to affect a “laddering” is prudent. Our clients have bond exposure through ownership of mutual funds, exchange traded funds (ETFs) or individual bonds.

  1. Ultra-short term – maturities of less than 1 year, will have lower yields than bonds with longer maturity but will better maintain their value as interest rates rise.
  2. Short term – maturities of between 1 and 3 years and normally a higher yield than shorter term bonds. As rates rise their valuation will decrease more than ultra-short bonds.
  3. Intermediate term – bonds with maturities of 4 to 6 years. These bonds will have a higher yield than shorter term bonds but will generally decrease more in value as rates rise.
Floating Rate Bonds

Also referred to as bank loans, these are corporate bonds that have a yield which varies with an interest rate benchmark such as the LIBOR or the prime rate. If the benchmark rate goes up, so does the yield paid by the bond. Floating rate bonds also have various maturities.

Inflation Protected Bonds

These are treasury bonds with principal that varies with inflation- the coupon remains the same. A purchase for $1,000 with a 2% coupon, and therefore with an annual yield of $20, will have a slightly higher dollar yield ($1,010 x 0.02) if inflation increases by 1%.

Stable Value Funds

These funds pay a contract rate of interest and therefore have no interest rate risk over the contract term. They may restrict timing and the amount of withdrawals and therefore might present some liquidity risk. Generally, a portfolio of bonds, stocks and real estate compose the underlying investments that allow interest to be paid to the investor.

Structured Notes

This is a class of investments with a return that is contingent upon the performance of one more market indices. We attempt to ladder individual notes to achieve a hybrid investment that has a stock component and therefore some market risk. Our approach is to ladder individual notes to mitigate that risk and attempt to achieve a return that would compare favorably to more conventional fixed income options.

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