Proving the old adage that if you say something
long enough eventually it will be true, interest rates have now begun to rise
after close to two years of forecasts predicting this event. The fact of the
matter is that a combination of inflation fears sparked by high oil prices and
both massive trade and fiscal deficits are finally taking their toll. Interest
rates are steadily moving higher and look likely to continue to do so for at
least the near future. So what can you do to adapt your bond portfolio to a
rising rate environment? Here are some basic ideas to consider.
Shorten maturities: The yield curve is very
flat at the moment so there is very little yield advantage to owning longer
maturities. Shorter maturities are less affected by rising rates because you
are locked into them for a shorter period of time. When your bond or note
matures you should be able to reinvest it at a higher rate so it pays to limit
your maturities and get it reinvested sooner.
Buy bonds with higher coupons: The higher
cash flows that are generated from high coupon, premium bonds provide a good
cash flow you can reinvest at progressively higher rates. While this is not as
helpful as having the ability to reinvest the whole value of the bond, it does
help soften the pain.
Buy callable bonds that trade at premium prices.
These bonds are generally known as "cushion" bonds. When you buy a callable
bond at a premium you generally assume that the bond will be called at the
first opportunity, and as such calculate the amortization of the premium paid
over a short period of time (yield to call). If interest rates rise
sufficiently to make the bond unattractive for the issuer to call then the
premium you thought you’d be amortizing over a few months or years now gets
amortized over a much longer period of time. This causes your effective yield
to rise as you now assume the bond will be outstanding to maturity (yield to
maturity).
Reduce credit risk: This is an important
point that often gets missed. When interest rates are rising creditworthiness
tends to diminish. Higher rates increase business costs, tend to lead to lower
sales and a general cooling of the economy. These are all factors that weaken
corporate creditworthiness. Since credit spreads, or the extra yield you
receive to take credit risk, is based on a company’s relative credit, anything
that erodes the perceived ability to pay will push those spreads wider. Simply
put, when business slows, corporate bond prices will tend to drop as investors
demand more yield to take on the increasing perceived risk. The time to
upgrade your credit exposure is early in the cycle, when rates first start to
rise and before corporate earnings start to fall.
Bonds are an important part of a diversified
portfolio and I do not encourage investors to attempt wholesale market timing
of interest rates. However, history has shown that interest rate trends, once
well developed, usually take several years to play out and as such a little
effective trimming in your portfolio may be warranted. But be careful, bonds
can be expensive to trade so don’t make unnecessary changes and seek the help
of someone skilled in bond investing unless you are fairly knowledgeable on
the subject.
As always, I welcome your questions and comments.
Randy Gridley
October, 2005
