Diversifying into Less Rate-Sensitive Sectors Expected to Reduce Rate Risk without Impairing Return
Bond investors holding significant amounts of U.S. Treasuries and other high-quality credit should consider diversifying to less-interest-rate-sensitive securities, which may be used to shield portfolios against the risk of rising rates with minimal changes to the overall yield or risk position, according to a white paper from the BNY Mellon Investment Strategy and Solutions Group (ISSG).
The analysis suggests that bond-heavy investors should diversify their fixed income portfolios by implementing strategies better designed to weather interest rate rises without reducing returns.
"Amid persistent uncertainty and market volatility, investors continue to look for practical solutions for protecting portfolios against a range of key risks," said Charles P. Dolan, senior investment strategist for ISSG and co-author of the paper, Managing Downside Interest Rate Risk While Protecting Return and Diversification Objectives. "While we can't predict when interest rates will move, historic lows suggest there is only one way for them to go. We expect the cost of protecting against this risk will rise long before rates themselves."
The interest rates of U.S. Treasuries and investment grade credit are closely linked to interest rate moves and the value of those securities would drop during a bump in rates.
The report affirms the benefits of maintaining allocations to fixed income, including liquidity, the predictability of cash flows from bond assets and the benefits of risk reduction, particularly when investors flee risky assets during crises.
"We suggest, however, that investors alter their portfolio so they retain the desirable aspects of owning fixed income assets, but protect against the possibility of significant loss if interest rates revert to their historical level," said Chris Harris, investment strategist ISSG and a co-author of the paper. The report describes how a mixture of mortgage-backed securities, inflation-linked bonds, municipal bonds and a diversified credit exposure including floating-rate bank loans potentially may reduce the amount of uncompensated duration risk in many fixed income portfolios.
In addition to the diversification approach, the report details how investors can buy options to pay for a defined interest rate in exchange for a market-based rate, albeit with on-going costs. It also details an interest rate swap approach for investors with derivatives programs already in place. The report points out that all three approaches could be combined or adapted to suit individual needs.
ISSG said it has developed a forward-looking methodology that identifies the growth and inflation scenarios that could result in significant loss of capital in fixed income portfolios.
"We think this approach helps us design better portfolio defenses for our clients across different macroeconomic conditions," said Dolan.