Wh at i f I n t e r e s t R at e s R i s e ?
A Special Commentary Series
bond portfolio defense
While our economic forecasts suggest that rates will remain relatively low for some time, there remains
a risk that interest rates could rise in the future. Given the inverse relationship between interest rates
and bond values, a rising rate environment creates a challenge for fixed income investors. Along with
the fundamental asset allocation decision, another important decision investors must consider is which
securities to hold within each asset class—meaning, for example, what kinds of bonds to hold in the
allocation devoted to fixed income.
Bonds are often included in a portfolio for diversification and to provide income. There are a variety of
ways to achieve these goals while tempering the risk that rising interest rates can have on the portfolio.
In prior “What if Interest Rates Rise?” installments, we discussed the reasons why interest rates may rise in
addition to exploring bond characteristics and their degree of sensitivity to an increase in interest rates.
Here, we’ll review the fixed-income strategies investors can adopt within their portfolio to achieve income
and diversification while simultaneously protecting their portfolio for a potential rise in rates.
Bond Strategies
Laddered portfolio strategy
Investors can prepare for rising rates by laddering
their fixed income portfolios, which involves
investing in fixed-income securities with maturities
in sequential years. This means that as a bond comes
due, the proceeds from the lowest “rung” can be
reinvested at higher rates in a long-term maturity.
The laddered strategy provides investors with a
stream of payments while continually improving yield
on a per annum basis—assuming rates are rising.
Using a laddered bond strategy can’t fully eliminate
interest rate risk, but it can provide a mechanism to
help your portfolio adjust as rates rise.
Sample Laddered Portfolio – 10 Year Maturities
Today
1 Year Bond
2 Year Bond
1.25%
1.50%
10 Year Bond
3.50%
Average Yield
2.38%
One Year Later
Rates Increase 1%
Matured
1 Year Remaining
1.50%
9 Years Remaining
10 Year Bond
Average Yield
(Source: Janney)
WWW. JANNEY.COM • © 2013, JANNEY MONTGOMERY SCOTT LLC
MEMBER: NYSE, FINRA, SIPC • REF. 1305475 • BOND PORTFOLIO DEFENSE • PAGE 1
3.50%
4.50%
2.70%
Barbell portfolio strategy
A barbell portfolio, comprised of fixed-income
securities with short-and long-term maturities,
can help protect investors against rising rates, by
allowing investors to reinvest proceeds from the
maturing short-term securities into higher yielding
investments. Meanwhile, the long-term bonds
continue to provide a stream of income, which
can then be reinvested at higher rates. Similar to a
laddered strategy, a barbell can provide a systematic
approach to bond investing that can help address
interest rate risk, but cannot eliminate it altogether.
Short-duration strategy
Duration is a measure of a bond’s price response
to a change in interest rates, and is related to the
maturity of the bond along with the time it takes
for bond holders to receive all payments. Portfolios
carrying lower duration will absorb a smaller
price decline than intermediate or long-duration
portfolios when interest rates begin to rise.
Investors can create a short-duration strategy with:
•Floating rate bonds – Floating rate, fixedincome investments have variable coupons that
reset on a periodic basis using a benchmark,
such as LIBOR, and a spread over the
benchmark. When interest rates rise, the
coupons on those floating-rate notes or bonds
will rise as well, minimizing interest rate risk.
•Shorter maturity bonds – Shorter maturity
bonds, holding all else equal, have shorter
duration than longer term bonds given that it
takes less time to receive all payments of the
shorter bond, including coupons and principal.
Bonds with a shorter maturity reduce interest
rate risk while allowing investors to avail higher
yields, as the bonds mature and the principal
received can be reinvested at a higher rate in a
rising rate environment.
•High-coupon bonds – High-coupon bonds,
holding all else equal, have shorter duration
than low-coupon bonds, given that the highcoupon bond repays at a faster rate. The
greater cash flows can be deployed at a higher
rate in a rising rate environment, improving
the yield of the portfolio.
Credit risk
In a rising rate environment, investors can take
additional credit risk, as opposed to interest
rate risk—that is, by looking at, and investing in,
corporate and municipal bonds whose higher
yields create an income cushion against market
value declines from higher interest rates.
Example of Credit Risk vs. Interest Rate Risk
Percent
1.5
One-Year Total Return
One-Year Total Return: Following 100 bps increase in rates
1.0
0.5
0
–0.5
–1.0
–1.5
5-Year Corporate
5-Year Treasury
(Source: Janney)
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MEMBER: NYSE, FINRA, SIPC • REF. 1305475 • BOND PORTFOLIO DEFENSE • PAGE 2
Protect Your Portfolio with
the Appropriate Strategy
In conclusion, despite the risk of rising interest
rates, investors have fixed-income options
available to them that both help achieve their
investment goals and mitigate the corrosive
impact of rising interest rates on bond values and
income. Investors can structure their portfolios
in a ladder or barbell shape, which allows for redeploying principal payments received from shortmaturity securities into higher yielding securities
as rates rise. Moreover, selecting investments that
have low duration will help insulate the portfolio
from a large drop in value if rates begin to rise
more steeply. Floating-rate securities and highcoupon bonds can help bring down the duration
of the portfolio, while providing a stream of
income and diversification benefits.
Each of the strategies listed above provides an
investment approach that can help investors deal
with the impact of rising interest rates. Investors
should also keep in mind that in the alternative
outcome of long-term falling interest rates, the
strategies above would need to be monitored
and your portfolio adjusted to accommodate the
changing risks and market conditions.
Your Janney Financial Advisor can help you identify
the appropriate strategy for your investment goals,
and which fixed-income securities can help protect
your portfolio against rising interest rates.
This report is for informational purposes only and in no event should it
be construed as a solicitation or offer to purchase or sell a security. The
information presented herein is taken from sources believed to be reliable, but
not guaranteed by Janney as to accuracy or completeness. Any issue named or
rates mentioned are used for illustrative purposes only, and may not represent
the specific features or securities available at a given time. For investment advice
specific to your individual situation, or for additional information on this or
other topics, please contact your Janney Financial Advisor and/or your tax or
legal advisor.