Interest rate risk is one of the biggest risks in fixed income markets today. Interest rates are going up and staying there, which means fixed income investors will be stuck with low rates for much longer than they would like. We’ve provided a brief guide to interest rate risk and how you can protect your portfolio from its negative effects. The key to combating this risk is researching different bonds and their associated risks before you invest.
Each type of bond has its own particular risks, so it’s important to understand those risks before investing. There are many ways to mitigate your exposure to interest rate risk (and other types of risk) when investing in fixed income securities.
These strategies aren’t available for all fixed-income investments but might help reduce the potential impact that fluctuations in an individual security or market segment have on your wider portfolio.
Know the Causes of Interest Rate Risk
Interest rate risk arises when the price of a bond falls due to a rise in interest rates. If interest rates increase, the price of existing bonds will fall as their coupon rate (and therefore their yield) will be less attractive compared to newly issued bonds with a higher coupon rate. If you hold a bond until maturity, you’ll receive your principal back regardless of how interest rates have changed.
But if you sell your bond before maturity, you’ll be impacted by changes in interest rates. If rates have gone up, the price of your bond will fall, which means you’ll receive less than you paid for it. If rates have gone down, on the other hand, the price of your bond will increase, meaning you’ll receive more than you paid for it. The chart below shows how the price of a bond changes as interest rates change.
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Strategies to Manage Interest Rate Risk
There are a number of strategies you can use to manage your interest rate risk. Bond Laddering – Laddering refers to the process of creating a portfolio of fixed-income securities with different maturity dates. This way, as each bond matures, you can reinvest in a new bond with a longer maturity date.
This will help you navigate the change in interest rates throughout the years and mitigate some of the negative effects associated with a rising interest rate environment. Coupon Matching – This strategy works by finding bonds with similar coupon rates. You could also combine this strategy with coupon matching by finding bonds with similar yields. If rates increase, the price decline of your portfolio will be less extreme than if you owned bonds with high coupon rates.
Adjustable-Rate Securities and Covenants
When interest rates decline, fixed-rate bonds become more attractive. They also become more attractive to investors, which can drive up their prices and, in turn, push their yields down. But if you own an adjustable-rate security (ARM), this doesn’t matter. You’ll receive the same interest rate as the bond’s underlying reference rate, regardless of what happens to the broader market or economy.
One drawback is that you’ll also see your principal decline as the bond’s price increases. This happens because each payment is based on the lower principal amount. But as interest rates increase, the principal will rebound. This may be a small price to pay for the certainty of an interest rate that will stay the same for the life of the bond.
A floating-rate bond is one whose coupon rate will change along with a specified reference rate. If the reference rate increases, the coupon rate on the bond will also rise. And, if the reference rate decreases, the coupon rate on the bond will also fall. If a bond’s coupon rate changes, the price of the bond will fall.
But if interest rates increase, the price of the bond will fall even more, which means you’ll get less for your money. The rate on the bond can be tied to a variety of different reference rates. The most common are the one-month LIBOR rate and the three-month LIBOR rate.
By diversifying your portfolio across different bond maturities, you can help offset the negative impact of rising interest rates. Since short-term rates are more sensitive to changes in economic conditions and expectations, they are more likely to increase as rates rise. Longer-maturity bonds, on the other hand, are less sensitive to these changes. They have a lower duration, and won’t be as heavily impacted by higher rates.
This strategy is also known as a “negative duration strategy.” It involves shortening your duration in response to a rise in interest rates. If you own a portfolio that consists mostly of long-term bonds, you could sell some of those bonds and use the proceeds to purchase shorter-term bonds. This will reduce the impact of rising rates on your portfolio.
A well-diversified portfolio is less susceptible to the impact of rising rates. This is because a diversified portfolio will consist of bonds from many different issuers and industries, so a change in rates won’t impact one sector or type of security as much as others. The best way to diversify your portfolio is by using a proven asset allocation strategy.
You can use short-term strategies to protect your portfolio from rising rates. These strategies may be particularly useful if interest rates are expected to rise relatively quickly. Contango Strategy – This strategy involves purchasing bonds that have a contango. A bond has a contango if its future price is greater than its present price. This is the case when current rates are greater than future rates, which is the case with most fixed-income securities.
Convexity Strategy – This strategy involves buying bonds with a convexity. A bond has a convexity if its future price is less than its present price. This is the case when current rates are less than future rates. A convexity strategy is more effective in a rising interest rate environment.
Resistor bonds are hybrid securities that offer some protection against rising rates. They are similar to floating-rate securities in that their coupon rate will change along with a specified reference rate. But the coupon will remain equal to the stated coupon of the security, even if the reference rate changes.
This makes them more like an adjustable-rate security (ARM). One advantage of resistor bonds over ARMs is that you can lock in your interest rate and principal amount before the bond is issued. This will provide some protection against rising rates, although it’s important to note that they are not 100% immune to rates.
Consider Floors and Covenants
Floors and covenants are terms written into a bond offering additional protection against rising rates. Floors are minimum rates of return that the bond pays, regardless of prevailing rates. Covenants are restrictions on the issuer’s actions, such as repaying debt or making certain payments.
With a floor, you receive the minimum rate of return regardless of what happens with prevailing rates. With a covenant, the bond issuer promises to pay you the specified amount regardless of what happens with prevailing rates. Both types of security will provide some protection against rising rates.
Use Leverage to Enhance Returns
Leveraging your portfolio is another way to boost returns. You can do this by using margin on your existing holdings or by buying additional securities with debt. When interest rates are rising, fixed-income investors are looking at low rates for the foreseeable future.
Generally, the Federal Reserve (Fed) will keep interest rates low as they attempt to stimulate economic growth. This means that borrowing money will be relatively inexpensive and fixed-income investments will offer low rates of return. Using leverage can help enhance your returns in this low-rate environment.
Interest rate risk is a real and significant risk in the fixed income market. There are many ways to combat this risk and protect your portfolio, but they aren’t available for all fixed-income investments. To effectively combat this risk, you need to research different bonds and their associated risks before you invest.
Each type of bond has its own particular risks, so it’s important to understand those risks before investing. Once you’ve done this, you can make informed decisions about which bonds will yield the best returns given the current climate and which will provide the most protection.