Fixed Income Investment Strategy

importance-of-savingWith interest rates at historical lows, fixed income investors are searching desperately for ways to capture additional yield. For some investors, an option may be to lengthen the maturity of bonds within their portfolios. While this strategy may provide some relief in the short-term, we believe many investors do not adequately weigh risks over the long term. To understand these risks, we believe it is necessary for an investor to seek the answers to the following questions:

 

  • What factors impact the direction of interest rates? 
  • How do bond values react to a change in interest rates? 
  • When will rates go up?

 

We believe it is best to start out with a general overview of what factors impact the direction of interest rates. For this discussion, it is necessary to look at short-term rates (less than five years) and longer-term rates (five years-plus) independently. Short-term rates are primarily driven by the Federal Reserve (Fed). Fed policy is implemented through setting what is referred to as the Fed Funds Rate. The Fed affects short-term rates by lowering or raising the Fed Funds Rate. Such changes in the Fed Funds Rate directly affect fixed income securities with maturities of less than five years. In short, the interest rates of short-term securities move in the same direction as the Fed Funds Rate.

The Fed’s impact on longer-term rates is not as direct. Long-term interest rates have historically been driven by the market’s expectation for inflation. In short, rates rise in anticipation of inflation and fall in anticipation of deflation. In recent years, however, the Fed has played a more active role in determining longer term rates through programs where the Fed actually purchases longer-term U.S. debt securities. These purchases artificially increase demand which leads to higher prices and, in turn, lower yields. This government intervention has made it much more difficult to anticipate the direction of longer-term rates.

How do bond values react to a change in interest rates?

Simply put, if rates rise, the market value of a bond will go down and if rates fall, the market value of a bond will go up. One way to think about it is if you bought a bond last week with a 5% yield and this week an identical bond offers a 6% yield. Why would anyone pay you the same price to earn 5% when they could now earn 6%? Thus in order to sell your bond, you need to adjust the selling price downward so that it offers the new going rate of 6 percent.

When comparing longer maturity bonds with shorter maturity bonds, it is important to note that the market values of longer maturity bonds are impacted to a greater degree by changes in interest rates. The reasoning behind this is due to the fact that you will have to live with the current coupon for a longer period of time. This, in a nutshell, is interest rate risk. Investors measure interest rate risk by a measurement that is referred to as duration. Duration is a complicated calculation that takes into account market yields, present value, coupon rate, maturity and call features. Duration is expressed as a number of years. A good rule of thumb to evaluate your risk is when interest rates increase (decrease) 1%, then a bond’s value will drop (rise) by approximately the bond’s duration. For example, a 30-year Treasury bond with a duration of 19 will lose 19% of its value if 30 year interest rates increase just 1% above current levels.

When will rates go up?

The Fed has indicated its intention to keep the Fed Funds Rate low until late 2014. As a result, we do not anticipate a material rise in short-term rates prior to that time. As discussed in the 2nd quarter 2012 Viewpointe, longer-term rates are in the midst of a tug-of-war between the Federal Reserve and fixed income investors. Fixed income investors view current interest rates as artificially low and want to see them move higher. The Fed, on the other hand, is concerned higher interest rates will negatively impact a vulnerable economy and is therefore actively purchasing securities across the yield curve to keep interest rates low. Thus far the Fed has managed to keep an upper hand in this game of tug of war. We anticipate this will continue to be the case for the remainder of 2012.

In conclusion, with rates at historical lows, we believe a rise in interest rates is inevitable within the next couple of years. While a sustainable increase in rates may still be several months out, we do believe those investors that focus on maturities of five years or less will be rewarded for their patience. Unfortunately, as this low rate environment drags on, it becomes increasingly difficult for those income dependant investors to not fall into the interest rate risk trap. For this reason we believe it is very important to remind our clients of the risks associated with extending the duration of one’s portfolio in what will eventually become a rising interest rate environment. For more information on this topic, or to review the interest rate risk within your particular portfolio, please feel free to contact your Horizon Advisor.