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RIAs Hedge Bond Holdings Against Fed Rate Hike

From cash equivalents to bond ladders, registered investment advisers deploy a variety of strategies to shield client portfolios.

  • Ed McCarthy

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 strategies?

“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 you’ll benefit.”

Cash equivalents hedge the yield curve’s short end, and that might be sufficient because “it’s not a foregone conclusion” that the U.S. Federal Reserve Board will follow its first rate hike with more increases, Benstead says. It’s 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. Bingham’s 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, Florida–based head of the RIA division for $770 billion Franklin Templeton Investments, notes that the Agg’s 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 higher rates.

Bond ladders with allocations to staggered maturities are another option, says Cedar Ridge’s 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 fund’s 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 won’t float higher. “They’re still not long-duration, but they’re not going to take advantage of just a pure funds rate rise that people might expect,” Benstead says.

Bingham’s 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 don’t 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 don’t perform well when you want them to,” he adds.

Advisers shouldn’t 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 that’s going to keep the pressure on the dollar, which is going to keep other currencies lower,” he says. “If you’re buying foreign bonds, you’re going to want to hedge the currency exposure, and that can be a form of interest rate hedging in a nontraditional way.”