The U.S. Federal Reserve and central banks around the world responded to the 2008 financial crisis by keeping key interest rates at or near zero. But as the economic recovery gains steam, there are signs that rates are on the verge of rising. Given this environment, investors may want to position their portfolios by using a defensive, yet tactical, approach that could help limit the downside while seeking to provide a decent stream of income and return potential.
Reduce portfolio duration. Duration is a measure of interest rate sensitivity, representing the percentage change in a bond’s price given a one percent increase or decrease in interest rates. Generally speaking, the longer a bond’s or bond portfolio’s maturity, the greater the vulnerability to a rise in rates. To shorten the duration of your portfolio, you can sell longer maturity holdings or replace maturing bonds with those carrying shorter maturities.
Investors might also consider laddering a portfolio; investing equal dollar amounts of bonds that mature in sequential years. As the bonds come due, the proceeds are reinvested at prevailing interest rate, which may help maintain the portfolio’s purchasing power.
Diversify fixed-income sectors.1 Just as different fixed income sectors fill various roles in a portfolio—such as income, liquidity, or total return—they also respond differently to interest rate changes. For example, high-yield bonds tend to be less rate sensitive and more credit sensitive than their investment grade counterparts, and may perform more like equities when rates increase.2 However, they also involve higher default risk than most other fixed income instruments.
International fixed income investments may also provide diversification benefits to your portfolio because a rise in U.S. interest rates won’t necessarily occur in other economies. In addition, some floating rate bonds, which have variable yields that reset periodically, based on interest rate changes, generally perform better in rising rate environments.
Assess your municipal bond exposure. Municipal securities are generally longer duration instruments than taxable bonds, and are more sensitive to rate increases. Consider reducing the duration of your municipal bond portfolio as previously described. Given recent tax hikes and the potential for more amid continued fiscal pressures, investors should weigh the rate risk municipals carry against their potential tax benefits.
Footnotes/Disclaimers
1 Asset allocation and diversification do not guarantee a profit or protect against a loss in a declining financial market.
2 Source: PIMCO, "Takeaway on Rising Rates," 2012.
Investment Considerations of Bonds:
Interest Rate Risk
Interest rate risk is the risk that the market value of securities in a portfolio might rise or fall due to changes in prevailing interest rates. All fixed income securities are susceptible to fluctuations in interest rates; all else being equal, if interest rates fall, bond prices will rise and vice versa.
Credit Risk
Credit risk is the risk that the issuer might be unable to pay interest and/or principal on a timely basis. Although municipal bonds are generally considered to be high quality investments, not every issuer has the same tax base or source of revenue.
Reinvestment – Reinvestment Risk
Reinvestment risk is the risk that the income stream from a given investment may be reinvested at a lower investment rate. This risk is especially evident during periods of falling interest rates where coupon payments are reinvested at a lower rate than the current instrument.
Call Risk
Some securities may be callable. If the security is called, the investor bears the risk of reinvesting the proceeds at a lower rate of return.
Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.
Lower rated (“junk bonds”) are more at risk of default than other bond investments.
International investing involves certain risks, such as currency fluctuations, economic instability and political developments.
Equity Securities’ prices may fluctuate in response to specific situations for each company, industry, market conditions, and general economic environment.
Interest in municipal bonds is generally exempt from federal income tax. However, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one’s state of residence and, local tax-exemption typically applies if securities are issued within one’s city of residence.
Morgan Stanley Smith Barney (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors do not render advice on tax and tax accounting matters to clients. This material was not intended to written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. You should always consult your own legal or tax advisor for information concerning your individual situation.
Article by McGraw Hill and provided courtesy of Morgan Stanley Financial Advisor.
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