The Surprising Solutions to Managing a Rising-Rate Environment

What should bond investors do when rates are rising and the credit cycle is ending? Perhaps not what you would expect. But getting this right can be critical for the health of your fixed-income allocation.

Knowing how to position your portfolio these days isn’t easy. Interest rates are rising, credit spreads are tight, and inflation expectations in the US and some other developed markets are rising. This has pushed US Treasury yields higher and has some economists—including ours—pricing in as many as four Fed rate hikes this year.

As we noted in a prior post, investors in these conditions often respond by reducing their duration, or interest-rate exposure, and taking on credit risk. Return-seeking credit assets such as high-yield corporate bonds tend to do well when growth accelerates and interest rates rise, while rate-sensitive government bonds struggle in those conditions.

Reducing duration modestly in the early stages of a rising-rate cycle may be appropriate, depending on a number of factors, including relative opportunities in credit, investment objectives and risk tolerance. But we’ve found that investors often tilt too far toward credit. This exposes them to credit risk at a time when asset valuations are already stretched and the credit cycle is nearing its end. It also leaves them without the diversification that interest-rate exposure provides.

Being short duration can be costly when higher rates start to put the brakes on the credit cycle and cause economic growth to slow. In those conditions, exposure to interest-rate–sensitive assets such as US Treasuries adds to returns and helps offset credit losses.

How can investors avoid falling into this trap? Here are a couple of solutions to consider:

Invest in a barbell strategy. This approach balances interest-rate and credit risk in a single strategy overseen by a single manager who can alter the weightings as valuations and conditions change. A well-constructed, well-managed barbell strategy should help to minimize risk by preventing investors from leaning too far in either direction.