Interest rates in the US rose over the month on fears that the Fed would end its bond purchase program earlier than anticipated. The 10 year Treasury yield rose from 1.70% to 2.16% and the broad bond market fell 1.78%. As interest rates rise bond prices fall and thus large increases in interest rates can have a negative effect to a bond portfolio. As a result of potential rising interest rates, how is RWM positioning your portfolio to reduce interest rate risk?
RWM is taking several steps to combat the potential harmful effects of rising rates. First, we tilt the fixed income side of the portfolio from a market neutral allocation, which has an average maturity of approximately 7.3 years, to a shorter term position. Short Term bonds are not as negatively affected by rising rates and thus, all else equal, short term bonds will see smaller losses than longer term bonds.
Secondly, we diversify the portfolio broadly across bond sectors including corporate and government bonds. Different types of bonds react differently to rising rates depending on the market cycle. By diversifying the bond portfolio across many types of bonds it enables the portfolio to invest in bonds that are less sensitive to interest rate movements.
Finally, we diversify the portfolio internationally. While rates may rise in the US, interest rates can be moving in different directions globally. By exposing the portfolio to different yield curves it provides the potential to be invested in markets were rates are flat or falling. The diversification potential is shown by the performance of international bonds when interest rates in the US are rising. Since 1985, when viewing one year periods where rates have risen in the US, the index of short term international bonds has returned 4.8% compared to gains of only 2.3% for five year US government bonds and a loss of 0.3% for ten year government bonds.
The concern of interest rates rising is also a relatively short term issue. As rates are rising the bond funds held in the portfolio are continually reinvesting maturing bonds in new bonds at the prevailing higher interest rates. As a result the bond funds are buying bonds with higher yields and moving out of older lower yielding bonds, which help investors. Thus, price declines are temporary losses until bond funds move into holding a portfolio of bonds issued at the higher existing rates.
While US interest rates rose in May and are likely to rise more in the future, by having a shorter term portfolio that is broadly and internationally diversified an investor can help mitigate the short term effect rising rates have on a bond portfolio.
Index Performance May YTD Trl 1 yr.
US Stock (Russell 3000) 2.36% 15.55% 27.88%
Foreign Stock (FTSE AW ex US) -2.22% 4.67% 26.52%
Total US Bond Mkt. (BarCap Aggregate) -1.78% -0.91% 0.91%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) -0.49% -0.11% 0.35%
Municipal Bonds (BarCap 1-10yr Muni) -0.91% 0.27% 1.90%
Cash (ML 3Month T-Bill) 0.01% 0.03% 0.12%