Concerns about rising yields are in vogue once again. As we discussed last week, worries about the national debt, the recent US credit downgrade, and a Fed that appears to be content with a “wait and see” approach have driven long-term yields higher. If you’re among those worried about rising rates, there are some strategies you can use to mitigate your risk.

Concerns about rising yields are in vogue once again. As we discussed last week, worries about the national debt, the recent US credit downgrade, and a Fed that appears to be content with a “wait and see” approach have driven long-term yields higher. The US Treasury 10-year Yield Index (TNX) recently returned to a buy signal, crossing above 4.6% and further out on the yield curve the 30-year yield index touched 5.15% last week, matching the multi-year high it reached in 2023. Rising yields are detrimental to much of the core bond market, i.e., the Treasuries and investment grade bonds that make up much of the US aggregate bond index. If you’re among those worried about rising rates, there are some strategies you can use to mitigate your risk.

Floating Rates

As the name implies, floating rate securities do not have a fixed coupon rate. Instead, the rate is typically set at a predetermined spread to a reference rate (e.g. SOFR + 200 basis points) and resets at a fixed interval.

Because the next coupon reset is never too far off, the price of a floating rate security will not move significantly due to changes in interest rates and when there are small changes, the price should return to par value at the next reset date. This is obviously advantageous in a rising-rate environment, as floaters will not experience significant price declines like fixed-rate securities. However, the flipside is that floaters will not experience price appreciation in a falling rate environment and their coupon rates will decline. Put simply, in a rising rate environment, all else equal, a floating rate security will outperform a fixed rate. And in a falling rate environment, the reverse is true.

While floating rate securities are mostly free of interest rate risk, they still carry default or credit risk and downgrade risk. I.e., while the price of floaters is largely immune to changes in interest rates, a credit downgrade of the issuer can result in price impairment. While they are not without potential drawbacks, floating rate securities can be a simple and effective way to protect your clients' fixed income allocation in a rising rate environment.  Those interested in adding floating rate exposure may want to consider the iShares Floating Rate Note ETF (FLOT) or the VanEck IG Floating Rate ETF (FLTR)

High Yield/Short Duration

The simplest way to protect a fixed income portfolio from a rise in interest rates is to shorten its duration. However, in a normal rate environment – one with an upward sloping yield curve – this typically also means lowering your yield.

One way to offset a loss of yield from reducing duration is increasing exposure to high yield bonds. Luckily, high yield bonds, in and of themselves, can also be an effective way to reduce interest rate risk. High yield bonds usually have relatively high coupons and a bond with a high coupon will have a lower duration than an otherwise equivalent bond with a lower coupon.

Of course, adding high yield bonds to a portfolio means increasing your credit risk. However, we typically see rising interest rates during times of economic expansion, which generally results in higher corporate profits and an increase in companies’ ability to service their debt. Therefore, we tend to see declining default rates in this type of environment, which can cause a narrowing of credit spreads. All else equal, tightening credit spreads result in price improvement for high yield bonds and can potentially mitigate the effects of rising interest rates.

For a variety of reasons, high yield bonds are typically issued with shorter maturities relative to other types of bonds. This characteristic, combined with their higher coupons, means there is an ample supply of bonds that are both high yield and short duration. Due to the credit risk of high yield bonds, credit analysis and issuer diversification are paramount, which can make the construction of a high yield bond portfolio an onerous problem. Luckily, there are single CUSIP products, e.g. ETFs, available that take care of this problem, a few of which are listed below.  

An economic downturn has been a worry recently and high yield bonds typically don't perform well during periods of economic stress, as credit spreads tend to widen. As a result, high yield bonds may be a less attractive option than in prior periods when rates have risen. However, the yield curve is currently relatively flat – the yield of three-month Treasuries is only about 12 basis points below the 10-year yield.  As a result, it is possible to reduce your interest rate risk without sacrificing too much in terms of yield. For example, the iShares Short Treasury Bond ETF (SHV) currently has a 4.3% average yield-to-maturity and an effective duration of 0.30 years (Source: iShares).

Convertible Bonds

Convertible bonds are hybrid securities with features of both debt and equity. Convertibles give the investor the right, but not the obligation, to exchange the bond for a pre-determined number of shares of the issuer’s common stock. In a situation where the underlying equity value of a convertible bond is higher than its conversion price the bond will generally trade much like equity, i.e., the price of the convertible bond rises and falls with the stock price.

Because of their equity-like characteristics, convertible bond prices are often more driven by the equity market than interest rates. One of the drawbacks is that because of this, convertibles often have higher volatility than traditional bonds and, like high yield bonds, they are prone to significant underperformance in an economic downturn. Convertibles currently rank near the top of the Asset Class Group Scores fixed income rankings thanks to the recent rally in US equities. Those looking to add convertibles exposure can consider the SPDR Bloomberg Convertible Securities ETF (CWB) or the iShares Convertible Bond ETF (ICVT).

International Bonds

Global and non-US groups currently account for the bulk of the headcount at the top of the ACGS fixed income rankings. International bonds are not directly affected by US interest rates and therefore an allocation to international bonds can lower the (US) rate risk of a portfolio. The downside is that currency returns typically dominate fixed income returns and so what you’re primarily getting is currency exposure. We have seen pronounced weakness from the US dollar this year and there is no indication that trend is changing – the US Dollar Index (DX/Y) is currently trading in a negative on multiple consecutive sell signals – so we may continue to see strength from international bonds. But if your ultimate goal is less risk short-duration Treasuries or floating rates may offer a better solution.

Another way to protect your fixed income portfolio from rising rates is to simply side-step interest rate risk by holding your bonds to maturity. Assuming there is no default, when a security matures you receive its par value. However, constructing a well-diversified portfolio of individual bonds that you can hold to maturity is a complicated task that often requires a significant amount of capital available to invest. While traditional ETFs and mutual funds offer easy access to diversified bond portfolios, because they are perpetual in nature they cannot be held to maturity. Target maturity ETFs aim to address both issues.

Unlike traditional fixed income ETFs, target maturity ETFs hold individual bonds that each mature or are expected to be called in the same year. As the underlying bonds mature, the cash or cash equivalent holdings of the fund increase and upon the fund reaching maturity, the proceeds are distributed to shareholders. Because these funds have a target maturity, they can be used to create a held-to-maturity portfolio to protect against capital losses due to rising interest rates.

Target Maturity Funds

Target maturity ETFs can also be used to create laddered portfolios. A laddered portfolio is one with allocations spread across several different maturities, e.g. 20% each to 1 to 5-year maturity bonds. A laddered portfolio provides liquidity and can help minimize interest rate risk. 

Even though the underlying bonds in a target maturity ETF are expected to be held until maturity, they are exchange traded, and therefore the market value and NAV of the fund will still be affected by interest rate movement. Therefore, it is important to understand that ultimately, as the bonds near maturity, the NAV of the fund should move toward the par value of its holdings and the fund will receive par value for its bonds (excepting any potential defaults), which will in turn be distributed to the fund’s investors.

There are now target maturity ETFs covering several segments of the fixed income market from Treasuries and municipals to high yield and international. The two main providers of target maturity ETFs are Invesco with the BulletShares lineup and iShares with the iBonds suite. 

Of course, we have no way of knowing what the future holds for interest rates. Long-term yields currently sit near multi-year highs, so it’s entirely possible we could see rates come down from here. But if you are concerned about rates continuing higher and would like to take some risk off the table, adding exposure to one or more the areas we’ve outlined above can help you accomplish that.