What’s Hiding in Your Bond Portfolio? Identifying Risks and Opportunities
Prepared by George Rusnak, Managing Director, National Director of Fixed Income; J. Patrick Frith, CFA® Senior Fixed Income Style Manager; Lorely A. Machin, CFA® Senior Fixed Income Investment/Manager; Linda Boggs, Assistant Vice President, Investment Strategy Team
After a 32-year trend of declining interest rates, we believe we are beginning to see a reversal in fortunes for the bond markets. This reversal poses some significant risks. In our view, it is critical for bond investors to know what they own and understand what risks they may face as a result. Diagnosing those risks is the first step in determining what actions to take to help protect your portfolio during these volatile times.
It has been decades since bond market investors have had to react to a sustained, long-term period of rising rates. We expect to see gradually rising interest rates over the coming quarters. This change could reduce fixed-income returns and negatively impact the value of bond assets if not managed properly—given the inverse relationship between interest rates and bond prices.
The good news is that bond returns are comprised of both price changes and income.In this shifting investment environment for bond investors, we believe that some of the risk relating to the price of the bonds in your portfolio can be offset by using income-enhancing active management strategies.
Bond Returns: Benefits of Diversified Portfolios and Active Management
The total return of a bond investment consists of both income and price changes. When interest rates and bond yields rise, bond prices and market values fall. For many Bond mutual funds, and bonds sold before maturity, the anticipated rise in rates in 2015 could have a significant negative impact on bond market investment values.
Yet the amount of income earned by a bond can help to mitigate the total return impact of rising rates on bond prices. Further, by employing active fixed-income management techniques such as active portfolio diversification, yield-curve and credit-quality management-as well as portfolio structuring strategies to shorten maturities (duration) and raise average yields-investment managers can potentially enhance fixed-income portfolio returns in a rising-rate environment.
The Federal Reserve’s (Fed’s) decision to phase out, or “taper,” its bond-buying program was designed to keep interest rates low, it has increased the probability that bond markets could become more volatile in the future.
We would suggest that, due to the shift in Fed strategy, you may want to discuss your fixed-income holdings with an investment specialist who can help you identify the potential risks to your portfolio from rising interest rates. Understanding how interest rates can impact your portfolio will allow you and your investment advisor to devise specific investment strategies that may lessen such risks.
Understanding what you own: Diagnosing the hidden risks and opportunities in your bond portfolio.
A portfolio review can specifically quantify how your fixed-income assets will respond to interest-rate fluctuations-and help identify potential opportunities and risks. It includes an assessment of:
• Maturity profile. Your bond portfolio’s maturity distribution and interest-rate sensitivity is reviewed to identify duration risk and yield-enhancement opportunities.
• Portfolio structure. Portfolio restructuring opportunities-as well as sector, geographic, and issuer diversification-are evaluated. As asset allocation accounts for more than 90 percent of the variability of overall investment returns in a portfolio, it is essential to review your portfolio for proper diversification.
• Yield-curve strategy. An analysis of the current, and expected future, shape of the yield curve can help identify active management strategies that can be implemented to potentially enhance the yield and income return of your portfolio.
• Credit quality and risk. The credit quality and risk to your holdings could have shifted as a result of specific company risks or market fluctuations, so it is helpful to periodically evaluate both and assess appropriate investment changes.
• Tax-efficiency. Looking at the structure of your portfolio may help identify opportunities to minimize taxes through municipal bond investments as well as through gain/loss management.
Conclusion
In today’s changing interest-rate environment, a strategic evaluation of your fixed-income portfolio is an essential step to help you preserve assets,identify the potential to increase after-tax returns, and mitigate risk.
Fixed-income investments can help to lower the volatility of investment returns when included in a well-diversified investment portfolio. Fixed-income holdings also remain an important source of income. As the interest-rate trends begin to change, we favor the following strategies:
• Active portfolio management to help capitalize upon income-enhancement and duration-reducing opportunities
• Reduction of duration and maturity profiles to potentially lower interest-rate risk
• Investment in credit-focused sectors such as municipal and corporate bonds to enhance yield and potential return
• Global diversification to potentially reduce risk and enhance returns
• Use of defensive portfolio structures such as investment in premium bonds offering higher income potential
Finally, we favor diversifying income streams across the full spectrum of asset classes—from fixed income and real estate to equities and complementary assets. Your investment manager can evaluate those opportunities during your bond portfolio review.
We believe that now is a good time to focus on fixed-income planning. If you would like to request a bond portfolio review or discuss fixed-income strategies, please contact us to arrange an appointment.
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