How To Adjust Your Portfolio as the Fed Raises Rates

Written by: Mark Cole | Advisor Asset Management

The Federal Reserve put the investment world on notice recently that they would indeed embark on what they call “Quantitative Tightening” — or “QT” — by winding down balance sheet holdings and/or raising short-term interest rates to help battle the ongoing inflationary pressures in the U.S. economy. Opinions differ on whether they are behind and started on QT too late, but the point is they seem very committed to try to use the tools at their disposal going forward. This was in fact confirmed by the recent Fed Minutes release on April 6, not to mention the “fed speak” during commentary just last week. The danger is that if the Fed believes they are indeed late and feel like they have to raise rates faster than the economy can handle, an economic recession could result. One closely watched recession indicator is the spread between the 10-year and 2-year U.S. Treasury note. When yields on the 2-year Treasury are higher than that of the 10-year Treasury, this is called an “inversion.” Although we may not currently have a 10-year vs 2-year inversion, other parts of the curve are modestly inverted relative to the 10-year. Historically though if the 10 year and 2 year are inverted for any length of time this has been predictive of a recession in the future (usually within two years), but isn’t a sure thing and is only one data point that should be considered when deciding your point of view on whether a recession is coming or not. However, it is possible that what were once signals from the Fed may now be just noise.

Investors who have the view a recession could happen in the near term may want to consider portfolio adjustments now to potentially get ahead of any shocks in most asset classes. For fixed income investors specifically, they can improve credit quality or adjust exposure to more defensive sectors or credits than may not be as sensitive to margin compression in a low-growth or recessionary economy. Also, they might want to consider shortening duration of their overall portfolio. The term “duration,” in terms of bonds, is simply a measure of the sensitivity of the price to a particular change in interest rates (not necessarily maturity). Generally, the longer the maturity date, the higher the duration and thus increased price sensitivity to interest rate moves. Keep in mind that embedded optionality — such as call provisions or resetting coupons have — can shorten duration on instruments with longer maturity dates. Additionally, fixed income investors can manage duration in portfolios, especially in rising rate environments, by including individual bonds in lieu of other options. Individual bonds have the advantage of a definitive maturity date where the yield (barring default) at the time of purchase is known to maturity, giving the investor an opportunity to reinvest maturing bond proceeds at higher yields when those holdings mature.

Cash flow and duration management are just a few reasons to consider individual bonds. Laddered portfolios with a short/intermediate average maturity are popular in rising rate environments. One thing to keep in mind, however, is that if a recession is severe and the Fed starts to lower rates again, the Treasury market would rally. Spreads on credit would most likely widen more in that scenario, especially on lower-rated issues and could potentially impact pricing in a negative way. While current conditions may not lead us to think this is a likely scenario, it is something investors will want to consider. Lastly, we would also like to remind investors that bond portfolios should consider total return from income and price, not just price alone as the main driver. Over time, the income portion of the return should be more meaningful in a rising rate environment as coupon payments are reinvested at higher prevailing rates.

If a recession does surface it stands to reason that the profit margins of most corporations would suffer as well, particularly for those not in more defensive sectors or who may be already employing more leverage than their peers. When this happens credit spreads on corporate bonds (or other instruments with any kind of credit risk premium) tends to widen. Those credits that are more stable financially will tend to weather these storms better. As a microcosmic example, we can take a look at just a few months ago as inflation ramped up and the market looked ahead to more rate hikes and a potential coming recession. Below are charts showing the option adjusted spread for the A, BBB, BB and B rated corporate indices which illustrate that spread widening was more pronounced in the lower-rated credits during that period. Upgrading portfolio credit quality could help by potentially minimizing price deterioration in such an environment. Additionally, by using individual bonds it may be easier for investors to know what they own and more closely watch ratings on their holdings. Compared to the Bloomberg US Aggregate Corporate index, which widened about 50bps (basis points) to +143 over that two and a half month period (see Chart 1), the A rated Corporate index widened by only 40bps, the BBB rated Corporate index by just over 50bps and the B rated Corporate index widened by 130bps (see Chart 2).

Chart 1: Bloomberg US Corporate IG Option-Adjusted Spread [OAS] (Agg index spreads)

Source: Bloomberg | Past performance is not indicative of future results.

Chart 2: A, BBB, BB and B Corporate index OAS (spreads)

Source: Bloomberg | Past performance is not indicative of future results.

Considering these macro changes in the economic and rate environment, bond indices have started the year off with a negative return and the 10-year Treasury has started down about 9% year to date. The market could be pricing some of the coming rate increases and Fed balance sheet wind-down already, but there could also be more to come. After a period of very low yields and credit spreads post-pandemic given the amount of stimulus injected into the economy and risk assets, it is not that surprising. Whether or not a recession is on the horizon is yet to be seen, but if that is the view of the investor then making portfolio adjustments to reduce risks now may be prudent. While inflation measures make real yields negative currently, ultimately, higher net yields look more attractive for when those laddered portfolio proceeds get reinvested, in our view.

Net yields on investment grade corporates according to the Bloomberg US Aggregate Corporate Index yield to worst (YTW). The duration on this index is approximately eight months.

Bloomberg US Aggregate Corporate Index YTW, 2-year chart

Source: Bloomberg | Past performance is not indicative of future results.

Related: An Ill Wind Blows From the East