Content provided by Josh Jenkins, CLS Investment Research Analyst
With the Federal Reserve moving closer to the seemingly inevitable liftoff in interest rates, one thing on the mind of many investors is, “How will this affect my portfolio?” This is particularly true for those invested in an income-oriented strategy. Generally speaking, all income strategies carry some level of interest rate risk, and can therefore be negatively impacted when rates rise. CLS attempts to mitigate this risk within its income strategies through several approaches, including:
- Utilization of a globally diversified multi-asset allocation
- Management of duration
- Exposure to variable-rate securities
A globally diversified multi-asset allocation can help reduce interest rate risk in several ways. First, investing internationally provides exposure to countries engaged in different monetary policies. For example, the U.S. is currently moving towards a tightening of policy, but many other countries are actively easing their monetary policies. In addition, various asset classes, such as stocks, bonds, REITs, master-limited partnerships, etc., have differing levels of sensitivity to changes in interest rates. This happens in part because the return of one asset class may be impacted by other factors that do not affect another asset class in the same way. For example, MLPs are sensitive to the price of oil, stocks to the level of earnings growth, and corporate bonds to credit spreads. Combining assets whose prices are driven by different factors creates diversification and will generally reduce volatility and sensitivity to any one factor, including interest rates.
Duration is a key concept when thinking about interest rate risk because it represents a mathematically derived estimate of a bond’s sensitivity to interest rates. The higher a portfolio’s duration, the worse it will perform in a rising rate environment. Duration is closely related to the length of maturity and level of income paid. The longer the term to maturity and lower the income, the higher the duration. Currently, CLS’s Income Strategies have substantially lower durations than the Barclays Aggregate Index, which represents a good benchmark for the overall domestic investment-grade bond market.
Finally, exposure to variable-rate securities can be a great tool in reducing interest rate risk. Bonds and other bond-like investments, such as preferred stocks, bank loans, and convertibles, either pay interest at a fixed rate or a floating rate. The price of a bond that pays a fixed rate decreases when interest rates increase because newly issued bonds will pay the new, higher rate. The price of a bond that pays a floating rate will not fall when interest rates rise because its coupon will be adjusted upward with the increase in interest rates. The Income Strategies at CLS have substantial exposure to floating-rate securities.
Unfortunately, income investors cannot eliminate their portfolio’s sensitivity to rate movements altogether, as doing so would likely prevent them from generating their required level of income. A superior alternative would be a multi-faceted approach centered on a globally diversified multi-asset portfolio, management of duration, and utilization of variable-rate securities.