It’s important to know that the primary reasons for owning fixed income investments don’t change when market conditions, including interest rates, change. In addition to providing income, fixed income strategies are an important component of a well-diversified portfolio, often serving as a potentially less volatile option to offset equity market volatility.
The following will review how interest rate movements affect fixed income investments, the factors that can impact interest rates, and why certain fixed income strategies are typically less interest rate sensitive than others.
What drives interest rates?
To better understand the impact rising interest rates can have on your investments, you need to know the relationship between bond prices and interest rates, and the different factors that can influence short- and long-term rates. It is also worth noting that short- and long-term rates don’t necessarily move in tandem.
When interest rates go up, prices go down (and vice versa)
Typically, bond prices and interest rates move in opposite directions. That means when interest rates rise, bond prices tend to fall, and conversely, when interest rates decline, bond prices tend to increase. Likewise, the share price of a fixed income mutual fund or ETF may move up or down, depending on movements in interest rates and their effect on the value of the bonds held in the fund’s portfolio.
What is the federal funds rate, and why is it important?
The central bank for the US, the Federal Reserve (Fed), controls the federal funds target rate. This is the rate commercial banks charge other banks for overnight loans, but it also strongly influences the rates of other short-term investments. Generally, the Fed reduces the federal funds target rate to try and stimulate a sluggish economy, and may raise rates when the economy is thriving to prevent inflation from getting too high.
Factors that influence long-term rates
The illustration below shows the yields associated with bonds of different maturity lengths. While short- term rates are largely influenced by the Fed, long-term rates, as represented by yields of 10-year and 30-year Treasury bonds, are typically market-driven. Macroeconomic events influence long-term rates (such as economic expansions or contractions), inflation expectations, and supply and demand factors (including demand from foreign central banks).
This chart is for illustrative purposes only and does not reflect the performance of any specific fund. Past performance does not guarantee future results.
Inflation has historically influenced long-term rates
While different factors may affect interest rates at any given time, over the long term, inflation (or the rate at which the prices of goods and services are rising) has been a key driver. Inflation is often a sign that the economy is expanding, and expectations of growing inflation by the market may cause long-term rates to move higher.
Strategies to consider during a rising rate environment
Interest rate sensitivity can vary across sectors within the fixed income universe. Generally speaking, higher quality sectors (such as US government bonds) and longer duration bonds have tended to be the most vulnerable to interest rate volatility. The following strategies have historically been less interest-rate sensitive though they may be subject to additional risks.
How to prepare for rising rates It’s impossible to predict the exact timing and direction of interest rates changes. And, while rising interest rates will likely generate news headlines, investors should avoid overreacting. Instead, work with your financial professional to determine the best plan to keep your long-term investment strategy on track.
(1) Consider Credit-Oriented Strategies
High-Yield Bonds
Floating-Rate Loans
Credit-oriented sectors and, in particular, non-investment grade sectors such as high- yield corporate bonds and floating-rate bank loans, have historically been less correlated to US Treasuries as their performance is typically tied more to the overall economic outlook and corporate earnings landscape than interest rates.
(2) Keep It Short
Adjustable-Rate Mortgages
Short-Term Government Bonds
Floating-Rate Loans
Shorter duration securities are generally not as sensitive to long- term rate movements and can offer an attractive alternative to longer duration securities where rising rates typically have a greater effect on price and valuations.
(3) Go Global
Global Bonds
International Bonds
International and global strategies can seek to capitalize on the differing business cycles and economic conditions present around the world, and thus are typically less impacted by rate changes in the US.
The upside of rising rates
While there is often apprehension at the prospect of rates increasing, it’s important to remember the potential upside as well. Rising rates may indicate economic expansion, which can lead to increased interest payments over time.
What about stocks?
Most people associate rising interest rates with bonds, but many investors may not consider the impact on equities. When rates are rising due to economic growth,
it also tends to mean businesses and consumers are increasing their spending
on goods and services—all of which can be good for the stock market.
And alternatives?
Alternative hedge strategies can offer additional diversification to traditional stock and bond portfolios. Hedge strategies have historically shown a negative correlation to 10-year Treasuries. [5]
[5] Source: © 2023 Morningstar Direct. Based on the 15-year period ended 12/31/22. Hedge strategies are represented by the HFRI Fund Weighted Composite Index, 10-Year US Treasuries are represented by the FTSE 10-Yr US Treasury Index. Indexes are unmanaged and one cannot invest directly in an index. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are backed by the full faith and credit of the US government. Past performance does not guarantee future results.
All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. As interest rates rise, bond prices typically fall. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Floating-rate loans and high-yield corporate bonds are generally rated below investment grade and are subject to greater risk of default, which could result in loss of principal,
a risk that may be heightened in a slowing economy. The risks of foreign securities include currency fluctuations and political uncertainty. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
Alternatives: Hedge strategies are actively managed and could experience losses if an investment manager’s judgment about markets, future volatility, interest rates, industries, sectors, and regions, or the attractiveness or the potential appreciation
of particular investments prove to be incorrect. Short sales of securities involve the risk that losses may exceed the original amount invested. Merger arbitrage investments risk loss if a proposed organization in which the fund invests is renegotiated or terminated.
This communication is general in nature and intended for educational purposes only; it should not be considered tax, legal or investment advice, or an investment recommendation. Consult your financial professional for personalized advice that is tailored to your specific goals, individual situation and risk tolerance.
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