If and when U.S. interest rates rise, clients
fixed-income holdings are likely to lose value. Can advisers
hedge that risk with relatively simple and inexpensive
If you really believe that rates are going to go
higher, one of the purest-performing assets in a rising rate
environment would be cash, says Guy Benstead, partner
with credit manager Cedar Ridge Partners, a $150 million
registered investment adviser in Greenwich, Connecticut.
Because if the Fed raises the funds rate and it impacts
what banks are paying on certificates of deposit or what money
market funds can then earn and pay to their shareholders, then
Cash equivalents hedge the yield curves short end, and
that might be sufficient because its not a foregone
conclusion that the
U.S. Federal Reserve Board will follow its first rate hike
with more increases, Benstead says. Its also impossible
to predict if the entire yield curve will shift higher by the
same amount as a Fed funds rise.
When and if the first rate increase arrives, the
market expectation of future inflation is going to dictate what
happens on the longer end of the curve, Benstead says.
Currently, the market assigns a roughly 50-50 probability that
in December the Fed will raise the federal funds rate, which it
has held at zero to 0.25 percent since December 2008.
Shortening the duration of clients
bond positions is another easily implemented hedge. Kevin
Dorwin, managing principal at Bingham Osborn & Scarborough,
a $3.5 billion RIA based in San Francisco, says his firm uses a
low-duration fund for about 30 percent of its bond allocation
in tax-deferred accounts like IRAs and in taxable accounts for
clients with low tax rates. Binghams goal is to set an
overall duration of three and a half to four years for
clients fixed-income holdings by combining short-term or
low-duration funds with intermediate-term funds.
A short-duration strategy is particularly useful for
advisers who index their bond allocations to benchmarks like
the Barclays U.S. Aggregate Float Adjusted index. Pierre
Caramazza, St. Petersburg, Floridabased head of the RIA
division for $770 billion Franklin Templeton Investments, notes
that the Aggs duration in late October was about 5.5
years, a relative hefty exposure. He also cites
short-duration funds as a simple way to reduce exposure to
Bond ladders with allocations to staggered maturities are
another option, says Cedar Ridges Benstead. Buying bonds
maturing at three-month intervals up to a year allows for
interest and principal reinvestment at prevailing short-term
rates. Most advisers are very comfortable with a laddered
portfolio, Benstead explains. They get it, but the
yield and performance profile from a laddered portfolio is not
very robust, certainly not if their client demand is a 4, 5 or
a 6 percent or even higher rate of return.
Floating-rate funds that invest in bonds and other debt
instruments with adjustable coupon rates draw mixed opinions.
Benstead says floating-rate vehicles are fine, but
he suggests that advisers review a funds terms.
Some funds, especially those with levered high-yield loans,
have coupon floor resets based on Libor plus 250 or 300 basis
points. Those funds have attractive coupons, but until Libor or
the underlying index reaches the floor level, the rate remains
set and wont float higher. Theyre still not
long-duration, but theyre not going to take advantage of
just a pure funds rate rise that people might expect,
Binghams Dorwin is skeptical of floating-rate funds
because their performance tends to be highly correlated with
risky assets like equities, which reduces the diversification
benefit in a declining stock market. He also worries about a
potential illiquidity risk in some of the funds.
Although inverse bond
ETFs appear to offer a convenient hedge, Benstead and
others dont endorse them, particularly those using
leverage, pointing to management fees and the portfolios
operating procedures. In late October the average expense ratio
for inverse bond ETFs was 0.83 percent, according to ETF
tracking web site ETFdb.com. The combination of that cost and
the funds need to reset their portfolios daily can lead
to negative longer-term results, even when yields have remained
largely unchanged for the period, Benstead says. Inverse bond
ETFs might work in very short time frames, but
historically, they dont perform well when you want
them to, he adds.
Advisers shouldnt overlook the impact of higher U.S.
rates on the dollar, which affect foreign bond investments,
Dorwin warns. We are hedging all the foreign currency in
the foreign bond portion of our portfolio, because if interest
rates increase, particularly in the U.S., we think thats
going to keep the pressure on the dollar, which is going to
keep other currencies lower, he says. If
youre buying foreign bonds, youre going to want to
hedge the currency exposure, and that can be a form of interest
rate hedging in a nontraditional way.