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The Federal Reserve is now behind closed doors deciding the fate of interest rates as we head into 2017. Fed Chair Janet Yellen, along with most analysts, has speculated that this time around, the Fed meeting is almost sure to deliver a rate hike just in time for the holidays.
It’s been a long time coming, and the mere idea of higher rates has some investors feeling more than a little wary. It’s no wonder, considering that the near-zero-interest rate policy has been in place for so long now that it’s begun to feel almost normal. Even the small, quarter-percent hike last December, feels practically historic given the past 12 months of stagnancy. But barring some unforeseen major event, virtually all fingers point to a hike — which means, in our view, now is the time to make sure your portfolio is positioned for the turning tide.
The good news is that a shift in strategy doesn’t have to be dramatic. Instead, you can take steps to help strengthen your portfolio and put your clients at ease—all while keeping the most yield-producing components of your portfolio intact. Here are three suggestions to help get you started:
Strategy #1: Shorten muni bond maturities
Repositioning your portfolio with bonds of shorter maturities is a strategy employed across much of fixed income. An example of an asset class where this is frequently implemented by both institutional and individual investors is municipals bonds. The muni market was shocked by the U.S. election, given expectations for lower tax rates and rising inflation. These factors may be priced into munis at this point, but given the shift of the yield curve and its relative steepness, investors anticipating future rate increases may consider reducing their exposure to long maturity muni bonds. While the shortest part of the curve may be most immediately impacted by any future moves of the Federal Reserve, the intermediate part of the curve has historically provided a sweet spot in the muni market by providing a balance between yield and risk.
Strategy #2: Take advantage of floating-rate notes
A well-known income strategy for rising short-term interest rates is investing in investment grade floating-rate notes. Floating-rate notes have the potential to outperform fixed rate U.S. income securities when rates rise because of the floating rate nature of their coupon payments. Typically, coupons are reset every three months, allowing payments to rise along with increases in short-term interest rates. Of course, if interest rates stagnate or fall, these returns will likely fall back as well. Floating-rate notes may serve you well if you are looking to de-risk your portfolio with an investment-grade allocation or for simply managing secondary cash.
Strategy #3: Hedge credit exposures with U.S. Treasuries
High yield investors concerned with the direct impact of rising interest rates can hedge interest rate risk by shorting U.S. Treasuries. If analysts are correct about the potential impact of a Trump administration on inflation, then we may be looking at an uptick in rate hikes, which may actually benefit credit markets. In 6 of the last 7 calendar years when interest rates closed the year higher, credit spreads narrowed and high yield bonds turned in positive total returns. That’s a pretty good track record. Still, if rising interest rates are a concern, this strategy will allow you to participate in the credit markets while limiting the impact of rising rates. Should interest rates go north, you’ll have just the hedge you need to help keep things in balance.
No matter what decision the Fed makes this week, we believe sourcing income will continue to be an important goal for many investors, but they’ll need a portfolio that gives them options for handling different scenarios. Fortunately, implementing these ideas doesn’t have to be difficult. A number of exchange-traded funds exist that may allow you to optimize your income allocations —no matter which direction the market, inflation, or interest rates head in the future.
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