Importance of yield over price rise
While bonds are defined by their periodic interest payments, investors may not realize that income generates about 93% of total return over the long-term. That income is the periodic coupon payments, not the price movements. This is true for both high-grade and high yield bonds.
Certain strategies may help fixed income investors better position their portfolios in a rising rate environment.
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1. Investors should create a portfolio with sources of income diversified across fixed income asset classes
Investors can add greater amounts of higher yielding sectors, such as high yield bonds, investment grade corporate bonds, and select non-U.S. securities. For more conservative investors, short-term bond strategies that invest across short-term corporate bonds, asset-backed securities, residential mortgage-backed bonds, and commercial mortgage-backed bonds—all of which tend to offer higher yields than Treasuries—may be a wider choice because these would fetch above-Treasury returns within a shorter duration and with less risk exposure.
Exchange-traded funds (or ETFs) such as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK) track the performance of high yield corporate bonds issued by non-investment grade companies in the U.S. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) tracks the performance of 600 highly liquid investment grade corporate bonds of companies such as Verizon Communications Inc. (VZ) and General Electric Company (GE).
2. Switch to shorter-term securities to make it less sensitive to rising rates
Reducing your portfolio’s overall duration by switching to shorter-term securities could make it less sensitive to rising rates. Securities with higher maturity, or higher duration, are more sensitive to interest rate changes. As rates rise, a portfolio with a shorter duration will generally experience a smaller price decline than one with a longer duration.
3. Emphasize asset classes with less sensitivity to rising rates
Investors can increase the weight of fixed income securities with less sensitivity to rising rates in their portfolio. This strategy may include adding investment grade corporate bonds and de-emphasizing sectors with more interest rate sensitivity, such as Treasury bonds.
These strategies should help hedge your fixed income portfolios against an interest rate rise. However, since markets are unpredictable, you can only hope to mitigate losses as much as possible.
Read more about hedging strategies in our earlier Market Realist article, Hedging: You can profit from rising rates with fixed income ETFs.