Most investment and advisory firms have asset allocation models for their clients with titles ranging from conservative to aggressive. What you should keep in mind, especially in a possible rising interest rate environment is that most of the conservative portfolios will allocate a large percentage to fixed income securities. The allocation to fixed income might be anywhere from 65% to 100%. As a general rule of thumb, bonds will tend to fluctuate less than stocks and provide income so you will find that the more conservative the asset allocation model, the greater the allocation to fixed income. Seniors searching for income as well as wealthy individuals who wish to protect their principal tend to migrate towards the conservative end of the spectrum of the asset allocation models.
Since rates are at historic lows and have been trending lower for the past several years, bonds have enjoyed fabulous returns. As rates fall, the price of most bonds go up. Bonds issued with higher coupons (rates) will rise more than bonds with smaller coupons (assuming quality is similar).
When rates rise….
Rates are likely to go up. When and how much is obviously anyone’s guess and many smart Wall Street analysts will give you their opinion regularly. For the conservative investor whose objective is to protect their principal, you should be aware of the risk of rising rates.
A small rise in rates can create havoc in a fixed income portfolio. Just look at the returns for the month of June in every category of fixed income. They all suffered losses ranging from miniscule (-0.01% for US Short Treasury index) to mid-single digit losses (-5.93% for international high yield index). Many of the international fixed income indices are now carrying high single digit losses year to date. One month of negative returns can erase a year’s worth of income. One of the hardest hit categories was TIPS (inflation protected bonds). Just take a look at one example, Vanguard’s inflation bond fund fell 7.36% year to date through June 30th.
A 1% rise in a 20 year Treasury can cause an 11% drop in price. That’s a lot to make up with rates currently in low single digits. Unlike stocks which can rise for a multitude of reasons, bonds generally do not get another chance to rally until rates fall again. If we are the beginning of a rising interest rate cycle, how long might it be before you recoup that lost principal?
When History Helps….
One suggestion I have given folks in the past as an easy way to judge the possible downside risk in a portfolio or a fund is to look back at the past performance on a money manager or mutual fund. Not simply 1, 2 or 3 years but find a period where there was a lot of volatility and see how the manager or fund performed. If that kind of volatility took place again, would you be able to sit it out?
As an example, if you were investing in equity funds, you would want to see how the performance held up during a bear cycle such as October 2007 to March 2009. The S&P lost 56% during that cycle, how did the fund or manager perform?
That period works for equities to review downside performance. However, during that large decline in stocks many investors flocked to bonds. So bonds, especially higher quality bonds held up well. To help with the crisis, the Fed then unleashed its program of massive liquidity called QE for Quantitative Easing. As part of those programs, rates fell and bonds continued to rally. In fact, you may have done better owning bonds in some periods over the last few years you than investing in stocks!
Since you cannot look to the 2007-2008 period for a clue as to how the manager or portfolio might respond in a rising rate scenario, you need to find a period when rates were very low and started to rise. Over the past 20 years, both 1994 and 1987 were periods when rates began to rise and bonds took big hits. Can you see how your manager’s portfolio, the bond funds in the portfolio or the overall portfolio performed during these periods? There may not have data going back that far. So what can you do?
Take an in-depth look….
If you are working with an advisor you can ask them to give you more data about the portfolio’s characteristics. If you are a do-it-yourselfer then you’ll have to get ready to do some serious sleuthing!
First, take a look at the current macro allocation. How much is in stocks, bonds and cash? Next, check the prospectus to find out how much the allocation may shift between those various asset classes. Now, get more granular and find out how much is allocated to each category within the fixed income universe. You want to check categories such as mortgage backed securities, high yield, floating rate, emerging market bonds, Treasuries, etc. Again, find out if they have limits to adhere to in any of these classes.
Find out the philosophy of the manager. Do they believe the economy will “muddle through” so there is not a lot of risk in owning high yield and floating rate? Are they prepared for a rising rate scenario? Can they be nimble? Do they allocate a large amount to one asset class within the fixed income spectrum? Do they hedge the portfolio at all?
Then ask yourself if you are prepared to sit through some potential volatility and if so, how much and for how long? The last thing any investor should do is panic near the bottom after suffering for perhaps months or even years.
If you own individual bonds, you know that they will mature at a specific time and you might be more open to holding during volatile periods. However, if you own bond funds, you are invested along with other investors and any withdrawal demands may cause the manager to turn those paper losses in to real ones to pay out the investors who bail. This can add to the volatility and make it more difficult to hold on.
Check back for more articles on how to structure your portfolio for a rising interest rate environment.
About Kathy A. Boyle
President/Chapin Hill Advisors, Inc.
Kathy Boyle is founder and president of Chapin Hill Advisors, Inc. Chapin Hill Advisors, Inc. provides consulting and planning services for families, family offices, high net-worth individuals, businesses as well as not for profit organizations. Chapin Hill also offers investment advisory services including asset allocation as well implementation of both traditional and alternative investment portfolios.
Kathy is a regular commentator and guest on national television shows such as CNBC, Fox Business Network, NBC’s Nightly News, NY1, Bloomberg radio and personal-finance TV shows. Kathy has also been interviewed extensively for many publications, including The Journal of Financial Planning, Wall Street Journal, Research Magazine, and Investment News.
Kathy serves on the advisory board of the Westchester Land Trust and the advisory council of the NYC Chapter of the American Heart Association and serves on an environment planning committee in Pound Ridge, NY. She is very active in her local community and rescues homeless animals.
Registered Investment Advisory services are offered through Morse Capital Partners in Richmond, VA.
Disclaimer: This information is provided for general information only, and is not intended as personalized investment advice. Reading the above is in no way intended to be a substitute for individualized investment advice, and no conclusions should be drawn from this information regarding any potential investment. All readers should contact their professional investment, legal and tax advisors before entering into any investment or investment agreement. Past performance of any index, market, sector, or investment is not necessarily indicative of future returns. Any index referenced herein references historical results. They are also unmanaged and cannot be invested in directly. Some information in the above is gleaned from third party sources, and while believed to be reliable, is not independently verified. Please contact Kathy Boyle for more information at firstname.lastname@example.org.