How to Diversify, Achieve Income, and Manage the Current Interest Rate Market
- by John Paul Tancona
Special Note: All of the investment products discussed here, like all investment products, have risks. The discussion below is not a recommendation to any individual investor, rather it is a summary of some of the products and approaches available in the current investment environment. Investors should review each product discussed, in full, including all the related risks before choosing to invest.
The Federal Reserve has kept short term rates at .25% since 2008 while buying longer term assets in its Quantitative Easing Program. Now they are pulling back on the easing but also promising to keep rates low. This has led many of us to be concerned about owning fixed income assets in a possibly rising interest rate environment. However, reducing your bond allocations in your portfolio is not the best strategy, in our opinion. By doing this you are ignoring the diversification and income benefits of the asset class and increasing overall portfolio risk either by missing income by simply holding cash or exposing your portfolio to much higher volatility in the equity markets.
There are smart ways to navigate the markets and mitigate interest rate risks. Below are some ways to manage interest rate risk, diversify and achieve yield in the fixed income market
What is a Step-Up bond?
A Step-Up Bond is a callable fixed income security with a coupon that increases or steps according to a predetermined schedule. In a rising Interest Rate environment owning this type of bond reduces your risk and preserves your purchasing power.
Here is an example:
Goldman Sachs 3.25% 12/27/28
- Coupon 3¼ TO 12/19
o 4¼ TO 12/23
o 5¼ TO 12/25
o 6¼ TO 12/27
o 7¼ TO 12/28
- Price $96
- Yield To Maturity 4.623%
- Currently Callable at $100
How do Fixed to Floating Rate Preferred Stocks Work?
Another way to protect against rising interest rates is investing in Fixed to Floating Preferred Securities. These are preferred securities that are issued with a fixed rate coupon which changes to one that floats usually after 5-10 years. The coupon rate resets and typically floats vs. 3 month LIBOR. These securities tend to be less sensitive to changes in interest rates than fixed rate bonds or preferred stocks.
Here is an example:
General Electric 6.25% Perpetual Preferred
- Coupon is 6.25% until 12/15/22 and then floats at 3 month LIBOR +470.4 basis points
- Callable 12/15/22 semi-annually and if not called will float at 3 month LIBOR +470.4 basis points
What Opportunities Are There in Structured Products Linked to other interest rate markets?
Investing in Structured Products is another great strategy that often offers large fixed coupons in the 7% to 10% range for a year and then they float versus a specific benchmark like Constant Maturity Swaps or 3 month LIBOR. They will, therefore, track interest rates after the fixed coupon period. Many of the current Structured Products offer principal protection. These products are readily available and your representative can look over the market and find those that will best meet your objectives.
What Opportunities Are There in Structured Products Linked to Other Markets Like Equities?
These Structured Products often pay a very high coupon in the 7% to 10% range as long as an equity index like the S&P 500 does not go below a certain level. Some may be principal protected and some may not, but the trigger levels where payments are not received or principal may be reduced, are very low. An example is the S&P 500 may have to fall over 35% to hit one of these negative triggers. Each issue has its own parameters, and your investment representative can identify and present those that meet your risk tolerance profile.
Special Note on Structured Products: These products are generally issued by major banks, and all parameters, including coupon and principal payments, are subject to the credit of the issuer.
How can Portfolios Be Adjusted to Manage Interest Rate Risk?
Another plan would be to swap bonds in your portfolio to shorten maturity and duration. Shorter dated bonds are less sensitive to changes in interest rates and tend to fluctuate less in a rising rate environment. Obviously, the yield in shorter duration bonds will be lower, but you can pick up additional yield by either moving down the capital structure in a specific credit (e.g. from senior secured to a note) or investing in a similar sector with a lower credit quality. This could be a very effective strategy if rates rise without an increase in defaults in High Yield.
When investing, many investors want to ladder their portfolio. Laddering means buying equal amounts of securities with different maturities (2 years, 5 years, 10 years, 30 years.) If rates rise you can use the shorter duration proceeds to invest at the prevailing rate.
Many investors have reservations about buying bonds at a premium, but if rates rise, they may offer a cushion in price volatility. Most Premium bonds carry a larger coupon than what current rates offer. Your cash flow will be higher than bonds trading at par ($100) or at a discount.
As you can see, there are several paths one can choose besides parking your cash in a money market account earning next to nothing. Diversify your portfolio within the fixed income market and protect against price volatility and market fluctuations.
How does “Hold to Maturity Accounting” apply to individual portfolios?
Banks have the option of categorizing their performing bonds generally two ways – either as “Hold for Sale” or “Hold to Maturity”. Hold for sale bonds are marked to market frequently and fluctuate in price on the banks balance sheet. Hold to Maturity bonds are put on the balance sheet at their par values and price increases or declines are ignored while the income comes rolling in. It might be very wise for long term investors saving until retirement to adopt a “Hold to Maturity” attitude and purchase a diversified portfolio of bonds for income with maturities as far out as comfortable. Under this practice, investors can ignore the year to year price fluctuations and simply collect the interest payments and the full maturity payment when due. Because longer bonds most often yield much more than shorter bonds, except in the rare instance of an inverted yield curve, this approach will always achieve the highest overall expected yield from your bond investment dollar. If you build up an interest payment flow you can use that cash to dollar average into new “Hold to Maturity” Bonds in the future.
Rebalancing your portfolio and setting your focus is essential to maximizing your total return. Rebalancing may mean shortening duration, increasing cash flow and yield, laddering, and/or hedging against possible rising rates.
Sounds like a tall task. There’s where we can help. Our bond professionals have extensive experience with all types of bonds and different investment markets and can help you decide on the best course for you.
Investors must first realize their risk tolerance in current market conditions and then evaluate their portfolio’s asset allocation accordingly. With the S&P hitting all-time highs and rates possibly rising, it is imperative to review and rebalance accounts now. We have the tools and knowledge to help you navigate these difficult choices. In doing this we need to reset reasonable expectations, set a game plan, and stick to it.
The information in this notice is neither an offer to buy or sell securities in any jurisdiction where such offer would not be legal. The information in the notice is from resources believed to be reliable but we cannot guarantee the accuracy of those sources. If the securities discussed in this notice are a new issue then the information in this notice is qualified in its entirety by a prospectus or other similar disclosure documents for the issue. When this notice was issued, the securities discussed were available at the price offered but all future transactions in the securities are subject to availability and changes in market conditions. J W Korth & Company and its partners may own the securities mentioned herein and may profit from their sale. These securities may not be suitable for all investors. All expressions of opinion are subject to change without notice and are not intended to be a guarantee of future events. Opinions expressed herein are not intended to be a forecast of future events or a guarantee of future results or investment advice and are subject to change based on market and other conditions. If specific securities are mentioned herein, they may be speculative in nature