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While 10-year Treasury yields steadied in recent weeks, enough so that there are now inklings growth stocks could bounce back, 2021 remains a trying time for clients' fixed income allocations.
Ten-year yield gyrations and speculation that the Federal Reserve could hike interest rates sooner than previously expected are among the reasons advisors are flocking to favored rising rates destinations, including bank loans, floating rate notes (FRNs) and ultra-short term bonds.
Those have been dependable, if not predictable avenues for buffering client portfolios against the effects of rising interest for decades, but there's a rub: Limited credit opportunities.
“Shrinking credit spreads push corporate bond prices up. As a result, investors concerned about rising interest rates might consider a strategy that seeks to eliminate interest rate risk—the risk of loss from a change in interest rates—during rising rates while still potentially benefiting from improving credit spreads,” says ProShares Global Investment Strategist Simeon Hyman.
Rate Conundrum
As advisors well know, there are two primary considerations when construction the fixed income sleeves of client portfolio: Credit risk and interest rate risk and those risks are the primary sources of a bond's income.
The lower a corporate bond's credit grade, the higher its yield because investors need to be compensated for taking on elevated default risk. Likewise, a longer-dated bond, even one of exceptional credit quality, such as a 30-year Treasury, will sport a higher yield than a comparably rated issue with a lower duration, because the longer a bond's duration, the more sensitive it is to changes in interest rates.
Weighing rate risk and a need for income, particularly against today's low rate backdrop, often leads advisors to standard corporate bonds and the related funds, but those options aren't perfect.
“Short-duration corporate bonds are affected less by both kinds of risk, but reducing both risks simultaneously may not be the best strategy,” adds Hyman. “That’s because sometimes these two factors move in opposite directions. For instance, interest rates may rise because the economy is improving while at the same time, credit spreads are tightening.”
As for FRNs, as compelling as those bonds may be when Treasury yields spike – and they are compelling when that happens as recent history confirms – they limit both credit and rate exposure, meaning there's a cap on client returns.
Regarding bank loans, as attractive as they may be from a yield perspective, their coupon payments float with short-term rates. Additionally, banks loans aren't the most liquid corner of the bond market and there can be caps on how high coupon payments can increase even if rates rise, potentially leaving clients disappointed along the way.
It's Not All Bad News
Fortunately for advisors, there are avenues for grappling with the specter of higher interest rates while ensuring client portfolios are adequately positioned to capitalize on credit opportunities. Enter hedged-rate bond funds.
Interest rate hedged bond funds usually invest in corporate bonds, both investment-grade and junk, while featuring hedges to mitigate the ill effects of rising rates. Owing to the fact that the hedge is designed specifically to react to Treasury yields, the full potency of credit opportunity is retained by hedged bond strategies.
“Interest rate hedged strategies allow investors to benefit fully from changing credit spreads while specifically targeting Treasury rate risk and may also capture additional yield from wider credit spreads than would short-duration approaches, even if credit spreads stay the same, notes Hyman.
Obviously, there's no such thing as a free lunch in financial markets, but hedged bond strategies are pretty good deals and ease the burden of balancing income against rate risk.
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