Recommendation: Consider hedging against rising interest rates

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As the Fed continues to reduce its Quantitative Easing program, and the market anticipates a likely increase in the fed funds rate next year, Matt Tucker explores ways to attempt to hedge against rising interest rates in your bond portfolio.

I continue to get questions about how the Fed’s tapering of bond purchases, which is currently underway, will impact investors’ fixed income positions and how to best prepare a portfolio for rising interest rates. As I explained in a recent Blog post, we expect rates to rise gradually. There are several reasons behind this rationale, specifically: the Fed is gradually slowing down their bond buying program, and is expected to end it near the end of this year; the Fed has signaled that they likely won’t begin to raise short term interest rates until the middle of 2015; and overall the Fed has indicated that they want to provide a lot of transparency into their thinking on interest rates, which should allow for policy shifts to be incorporated more slowly into bond prices and yields.FRED holding and purchases

Market Realist – The quantitative easing (or QE) program began in response to the financial crisis of 2008. It caused the Fed’s balance sheet to balloon from $870 million before the recession to $4.4 trillion. The program is likely to end as soon as October.

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The Fed started reducing its monthly purchases in January of this year. According to the minutes of the Federal Open Market Committee (or FOMC) meeting, the Fed will add a final $100 billion to its holdings of Treasuries and mortgage-backed securities over the next four months and end the program in October. This outlook assumes the economy will continue to grow.

QE has focused on purchasing ten-year securities (IEF). But the program has affected yields across all maturities—from the short end of the curve (SHY) to the very long end of the curve (TLT). Consequently, investment-grade corporate bonds (LQD) and high yield bonds (HYG) are also affected.

The news of the end of the bond buying program has made investors worry about an earlier-than-expected rise in interest rates. But the Fed has shown that the end of the bond buying program doesn’t signal an early rise in interest rates. As Matt shows you above, long-term interest rates are likely to rise only by mid-2015.

The chart above shows the holdings and purchases of the Federal Reserve since 2010, when the QE program came into effect. The holdings should continue to rise until October, when the program eventually concludes.

Read the next part of this series to learn more about the challenges investors face in a rising rate environment.

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