Interest Rates Moving Higher: What Alternatives do Your Clients Have?
The Federal Reserve raised rates last Wednesday by a quarter percent or 25 basis points. Some advisors recently have expressed concerns for clients sitting in bond funds. Others have asked about alternatives that would provide bond like returns. First, let’s review why some clients might be worried about a rising rate regime in their portfolios.
Typically, a bond fund holds a collection of individual securities that collectively wind up with an effective duration to maturity. These holdings can be a mixture of government treasuries, corporates, or high yield among others. A bond fund’s total return is a blend between changes in the underlying market value of the holdings and the interest (coupon) payments. Above you’ll notice a sample of how rate changes can impact a single bond with 10 years to maturity. For example purposes, we show a current yield or interest rate of 2.5%. The coupon, what the bond pays annually in interest, is set at 2.5% as well. Payments are received semi-annually and the bond is perfectly priced at its par or original value of $1000.
We then illustrate what a change higher or lower would do to the market value of the bond. If rates were to go lower from here to 1.5%, the bond would increase in value by 9.25%. Rates moving higher by 1% would result in a market value loss of 8.38%. A 2% rise would result in a loss of 16.96%. Because interest rates are so low currently, future interest paid out would only marginally reduce those losses.
Now the remaining time to maturity, coupon amount, and payment frequency can result in a different result. The shorter the duration the less interest rate sensitive a bonds market value is. Therefore, you might have heard pundits on television promoting the advice to only use very short duration bond funds in portfolios. The problem with low interest payments, and even lower in short duration, is that your clients may not even exceed currently inflation which would result in a negative real interest rate.
What Are the Alternatives?
We’re glad you asked. Many advisors use bonds because of the stream of interest payments and lower historical volatility of returns. When the stock market has corrected, bonds have tended to not go down as much thus providing a ballast to portfolios. Yet with a rising rate environment and low interest payments, your clients may not keep pace with inflation.
Let’s face it, most of your clients probably would be content with as much upside volatility as possible. It’s the downside moves that they want to avoid. Our Buy and Hedge strategies allow for capturing most of the upside while instituting floors on the downside.
Our Internet Advantage Strategy Equity Long/Short aims to have a much lower standard deviation while being non-correlated to pure equity or bond holdings. Since the portfolio is generally either equal weighted long/short or neutral, this strategy looks to reduce the normal systematic market risk when the market shows signs of weakening.
Finally, clients looking for monthly income that appreciate historically low correlation to interest rates might find some interest in our HIPOS or High Probability Options Strategies. It comes in four risk profiles so you can right size it depending on your end clients’ needs and risk.
We know that your clients have been reading for years about what would happen to bonds if rates finally started to rise. For quite some time, it seemed the Fed would never actually go through with it. Yet as of this week the Fed raised the Fed funds rate and have indicated more may be on the way through year end 2017. Why not talk to one of us to see what alternatives to classic fixed income might be?