Though the Fed didn't raise rates this month, Heidi Richardson explains how to potentially prepare your bond portfolio for the rate regime change.
It has been nearly 10 years since the Federal Reserve (Fed) last raised interest rates, and though the central bank didn’t hike rates this month, higher rates look to be coming.
The exact timing of when isn’t as important as making sure your portfolio is prepared for an impending rate regime change, one where rates are expected to rise gradually and remain low for long.
How can you do this? I’ve already covered some potential opportunities to look for in stocks. When it comes to the fixed income portion of your portfolio, you may want to consider these two strategies.
Two Ways to Prepare Your Bond Portfolio
1. Know where to hold your duration
Duration is a metric that helps us understand how bond prices change in reaction to interest rate moves. Think of it as a measure of a bond’s sensitivity to interest rates. When interest rates change, a bond’s price will change in the opposite direction of rates by a corresponding amount. For example, if a bond’s duration is five years and interest rates rise one percent, you can expect the bond’s price to fall by approximately five percent.
Shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates. Therefore, if you are concerned about price losses on bonds, you may want to invest in bonds with lower durations. Low duration can mean less volatility or price risk.
While shortening duration can help mitigate interest rate risk, another approach to consider is one that balances exposure to the very front end of the curve with exposure to intermediate maturities for additional yield potential and lower volatility, given that rates are likely to rise slowly and stay historically low for the foreseeable future. Exchange traded funds (ETFs), such as the iShares Floating Rate Bond ETF (FLOT) and the iShares Short Maturity Bond ETF (NEAR), can help you shorten your duration.
2. Focus on credit
When you invest in credit, you are typically compensated for taking more risk via a higher yield. This additional yield on a riskier credit bond is called the credit spread, and it’s measured against a similar duration U.S. Treasury bond.
If you’d like to learn more, you can find the credit spread for a given fixed income fund in the “portfolio characteristics” section of each product page—it’s called the option adjusted spread or OAS.
In rising rate environments, credit spreads tend to move in the opposite direction to interest rates and can potentially generate income to help offset some of the impact of rising U.S. Treasury yields. As such, to prepare for rising rates, you may want to seek a potentially better balance of risk and reward by focusing on credit exposure. Exchange traded funds (ETFs) focusing on credit, such as the iShares 1-3 Year Credit Bond ETF (CSJ), can potentially help you do this.
While the coming rate rise cycle is likely to be gradual, you can begin to prepare your portfolios now, and continue this preparation over the coming months.
Heidi Richardson is a Global Investment Strategist at BlackRock. She is also Head of Investment Strategy for U.S. iShares.
Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.
NEAR is an actively managed fund and does not seek to replicate the performance of a specified index. Actively managed funds may have higher portfolio turnover than index funds.
This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
This document contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.
The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).
©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.