Three Ways to Keep Your Head Above Water as Rates Rise

Volatility in yields got you down? Fearful of more rising rates ahead? Worried your bond portfolio will sink into the red? We have strategies that will help keep you dry, even if the waves get high.

Three Rules for Surviving Rising Rates

1) Stay properly invested. Don’t shift to cash, which could soon have you lagging both income-generating bonds and inflation. And, don’t expect to time the end of the interest-rate cycle, either. Even the most seasoned bond managers can’t do that.

Also, don’t fall prey to the lure of floating-rate bank loans. Neither of their selling points—floating rates and seniority in the capital structure—is what it seems.

Loan coupons float, or adjust, based on movements in LIBOR. But they’re continuously callable, and they’re being called in massive numbers. Nearly three-quarters of outstanding bank loans were refinanced or repriced in 2017. That’s led to lower—not higher—coupons, despite the Fed having raised interest rates six times over the past two-and-a-half years.

As for seniority, more than half of today’s loan issuers have no unsecured bond debt on their balance sheets. That means default recovery rates are likely to be much lower than in the past.

Oh, and the quality of those loans has been getting worse. “Covenant-lite” deals lacking basic protections for lenders now represent more than 70% of the market. This suggests that default risk is far higher than many investors realize.

2) Lift a barbell. This approach balances interest-rate risk and credit risk in a single strategy run by one manager who alters the exposures to each as valuations and conditions change. This kind of strategy should help minimize risk by preventing investors from reducing duration too much and, conversely, from tilting too far into credit.

What’s more, while the interplay between interest rates and credit is always important, there are times when that interplay becomes the most important risk for investors to manage. This typically happens when a central bank’s attempt to slow a credit cycle is the key factor driving interest rates and bond yields higher. That’s what we believe is happening today.

3) Diversify, diversify, diversify. Diversification is an essential defensive strategy at this stage of the credit cycle. The key is to keep your horizons broad and be choosy. Today, blending exposure to attractive high-yield bond sectors—European banks, US energy companies—with positions in select emerging-market debt and US securitized assets offers a good mix of credits that generate high levels of income.