For the past three decades, fixed-income investors have benefited from the secular decline in interest rates and corresponding rally in financial asset values.
Since the onset of the credit crisis and the recession, rates have been pushed even lower, driven by the extraordinarily accommodative policies of the Federal Reserve and expectations for these policies to continue for an extended period. With the economy now showing some signs of a self-sustaining recovery, and the Fed's second round of quantitative easing coming to an end this month, fixed-income investors have shifted their focus to the risks that rising rates could present to their portfolios.
However, investors who recently jumped to the conclusion that rates would abruptly rise are missing the chance to think more strategically about their fixed-income portfolios.
We agree that the foundation for higher rates of growth and inflation are coming into focus, but they are a bit further off in the future. In the near term, economic growth, inflation and rates remain contained by structural head winds.
Now is still the time to capture spread income while shifting up in quality within sectors and getting more flexibility in managing duration risks in anticipation of the volatility that eventually will come when the rate environment shifts.
Although it seems likely that the Fed will want to begin pulling back on its accommodative policies in the next six to 12 months, it is hard to imagine that the Fed actually will seek to “get tight” within that time frame by seeking to retard growth significantly. This is especially true given the continuing weakness in housing and the uncertainty surrounding the budget and debt ceiling debates in Washington.
So rates are low and likely to go higher over the next year or so. But we don't know when.
What should investors do?
Financial advisers need to reconsider how to generate yield and total return in fixed-income portfolios. With rates at their lows, advisers should encourage clients to reduce their duration risk or invest with managers who have the flexibility to adjust duration rapidly and significantly.
However, bracing for volatility isn't the same thing as assuming that rates are moving higher across the yield curve.
Investors still should consider holding some exposure to non- government spread sectors of the market, including investment-grade or high-yield corporate debt, floating-rate bank loans, commercial- mortgage-backed securities and non-agency-mortgage-backed securities. The performance of spread sectors is less linked to the direction of interest rates and more to the fundamental credit strength of underlying issuers, which has been improving along with the economy.
In the near term, investors would be advised to move higher in quality within their allocation to spread sectors in order to protect their portfolio if growth should slow down.
CREDIT QUALITY
The best defense against the risk of rising rates is to be careful about credit quality, investing with managers who aren't just riding a sector bet but can do the analysis to identify the strongest credits. For many investors, this exposure is best achieved through an actively managed, dynamic and unconstrained bond fund, rather than a traditional core bond approach.
As such, the investor retains the expertise of a professional portfolio manager with the tools necessary to navigate a fixed-income marketplace wherein selectivity is increasingly important to investment success. The manager can adjust sector allocations in an effort to achieve above-market returns, while also seeking to maintain downside protection.
A core allocation to an unconstrained bond fund that can be flexible in managing the fund's rate risk and credit risk would help enhance the overall success of a client's fixed-income portfolio. Outside that core position, advisers can help clients add tactical satellite positions in order to increase the portfolio's diversification and income potential.
Of course, specific allocations for each particular asset will vary, based on an investor's goals, risk tolerance and time horizon — important considerations that should be discussed with every client.
The correct balance between duration risk and credit risk can provide attractive fixed-income returns while providing a cushion against market volatility.
There is an old Wall Street adage: “Don't fight the Fed.” But investors should also not be afraid of the Fed's shadow.
Peter Fisher is a senior managing director and head of BlackRock Inc.'s fixed-income portfolio management globally.
