Managing interest rate risk
Three strategies for the new fixed-income environment
- In the current environment of historically low yields, longer-duration investment grade portfolios are especially susceptible to interest rate increases. Interest rate risk can be mitigated in three main ways: investing in lowerduration, higher-yielding instruments, such as senior loans and corporate bonds; exploring investment opportunities in regions with stable or falling interest rates; and using derivatives such as futures.
- The complexity of managing the potential solutions to interest rate risk make an active approach especially critical.
UNDERSTANDING THE RISK
The return potential of traditional fixed income is not what it once was. The average yield on Canadian investment grade bonds is currently 2.47%.1 With Canada’s inflation rate at approximately 2.1%, investors are left with minimal real return. But there is another factor to contend with: the possibility that interest rate hikes will continue for the foreseeable future.
In the current environment of historically low yields, longer-duration investment grade portfolios are especially susceptible to interest rate increases, as the yields on these bonds will not offset the adverse price impact of rising rates. To illustrate, consider the Canadian investment grade bond universe. If rates rise by 1%, investors could realize a negative return on their investments (Figure 1).
Figure 1: Impact of a 1% interest rate increase on Canadian investment grade bonds
|FTSE TMX Canada Universe Bond Index|
|Yield to maturity (A)||2.47%|
|Price impact of 100 bps yield increase (B)||-7.59%|
|Total return estimate (A+B)||-5.12%|
Source: PC Bond, as at December 29, 2017
It may be tempting to conclude that the solution to interest rate risk is to simply reduce duration. However, lowering duration on traditional investment grade fixed income comes at the cost of lower yields. Investors can expect a yield to maturity of only 1.78% from the FTSE TMX Canada Short Term Bond Index, which has a duration of 2.7 years.2 This translates into a real return of essentially zero and the potential for negative returns if rates rise.
To mitigate the adverse impact of rising interest rates and low yields, investors may need to look beyond traditional investment grade bonds toward the wider universe of income opportunities and strategies. Options include:
- Shorter-duration, higher-yielding fixed-income instruments, including (a) senior loans and (b) higheryielding corporate bonds
- Fixed-income opportunities from geographic regions with stable or falling interest rates
- Hedging interest rate risk using derivatives, such as futures contracts
1. Reducing duration & increasing yields
(a) Senior loans
An allocation to senior loans can help reduce a fixedincome portfolio’s sensitivity to interest rate risk and boost its yield potential. The key feature of senior loans is their floating coupons. The yield on a senior loan is calculated as the London Interbank Offered Rate (LIBOR) plus a fixed spread. This means that when interest rates increase, so does the coupon. Thus, unlike conventional bonds, senior loans actually benefit from interest rate increases, as LIBOR generally goes up when the Fed raises rates.
Although senior loans are non-investment grade, they are secured by company assets, and are first in line for repayment in the event the issuer runs into serious financial trouble. They also have attractive historical yields (Figure 2).
(b) Low-duration high-yield corporate bonds
Higher-yielding, non-investment grade corporate bonds tend to be driven more by economic and companyspecific fundamentals than interest rates. This makes corporate bonds an attractive choice in an environment of synchronized global growth and particularly in the context of a U.S. economy that is poised to benefit from the Trump administration’s pro-growth policies of deregulation and lower taxes.
Higher yields can help offset the price depreciation that bonds experience in a rising rate environment. In addition, their relatively low duration – approximately 4 years vs. 7.59 years for the FTSE TMX Canada Universe Bond Index – can reduce their sensitivity to what many expect will be continued interest rate increases.
Figure 2: Yield comparison for select income-producing asset classes
Source: PC Bond, Credit Suisse, December 31, 2017. Government bonds represented by the FTSE TMX Canada All Government Bond Index; bond universe represented by the FTSE TMX Canada Universe Bond Index; IG corporates (investment grade corporate bonds) represented by the FTSE TMX Canada All Corporate Bond Index; high-yield bonds represented by the ICE BofAML US High Yield Index (USD); senior loans represented by the Credit Suisse Leveraged Loan Index (USD).
2. Alternative interest rate regimes
Not all jurisdictions follow the developed market trend toward rising interest rates. Select emerging markets have stable to lowering rates (Figure 3). This is a clear tailwind for local currency fixed-income returns, creating potential to offset the adverse effects of rising rates in developed markets.
Select emerging market bonds can also offer higher absolute yields, augmenting the ability of these instruments to offset interest rate risk in developed markets. Over 10 years, adding a 15% emerging market bond allocation to a Canadian core fixed-income portfolio adds nearly 0.5% in annual return with almost no change in volatility.3
Figure 3: Overnight policy interest rates
Source: Bloomberg, as at December 31, 2017.
Derivatives, and particularly futures, can be very effective for managing interest rate risk. A futures contract is an agreement to buy or sell a financial instrument at a predetermined price at a specific point in the future. U.S. Treasury futures are low cost and highly liquid and can be used to hedge interest rate risk. They are also a highly flexible instrument: contract maturities can be matched to reduce duration.
An investor who shorts Treasury futures will gain as interest rates rise because the price of the underlying Treasury bond falls. For example, assume an investor determines that a company’s strong fundamentals make the credit spread on a 10-year corporate bond an attractive opportunity. At the same time, the investor may be uncomfortable with the interest rate risk associated with the bond’s longer-dated maturity. By selling (shorting) futures, the investor can isolate and hedge out the bond’s exposure to interest rate risk while retaining exposure to the bond’s attractive credit spread (Figure 4). Another benefit is that, if the spread on the security narrows, the duration of a longer-dated bond will enhance returns even if interest rate risk is hedged.
Futures can also be used as an overlay for multi-asset investors who wish to reduce duration without having to materially change portfolio holdings. With futures, the investor can fundamentally alter the portfolio’s duration profile without having to add or remove physical securities. This overlay approach can be less disruptive and less costly than trading physical securities.
Figure 4: Duration hedging
Source: Adapted from Goldman Sachs Asset Management. For illustrative purposes only
4. Why active
As with any asset class, investing in fixed income entails tradeoffs between potential risks and benefits. Interest rate risk, the risk of unacceptably low yields, credit risk and inflation risk are the key hurdles fixed-income investors must constantly navigate, as their relative prominence changes with changing market conditions. Active management can be very effective for determining which of these risks – or combination of risks – poses the greatest threat at any given time, and when changing conditions bring a different set of risks to the forefront.
An active approach is particularly important for meeting today’s twin challenge of interest rate risk and low yields. The reason is that the main potential solutions to this challenge – senior loans, high-yield bonds, emerging market debt and derivatives – are complex asset classes. Grasping and managing this complexity, and the risks it gives rise to, requires specialized knowledge and a research-intensive, nimble approach – precisely what active management can offer.
Dealer use only. 1FTSE TMX Canada Universe Bond Index, as at December 29, 2017. 2 Source: PC Bond, as at December 29, 2017. 3 Morningstar, as at December 31, 2017. Core fixed income represented by FTSE TMX Canada Universe Bond Index. Emerging market debt represented by a blend of static allocations to the following indexes: 1/3 JPM EMBI Global Diversified TR USD (sovereign hard currency debt), 1/3 JPM GBI-EM Global Composite TR LCL (sovereign local currency debt) and 1/3 JPM CEMBI Diversified TR USD (corporate bonds). The information provided herein does not constitute financial, tax or legal advice. Commentaries are provided by the portfolio manager or sub-advisor responsible for the management of the fund’s investment portfolio, as specified in the applicable fund’s prospectus (“portfolio manager”). Statements by the portfolio manager represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Information presented should not be considered a recommendation to buy or sell a particular security. Specific securities discussed are for illustrative purposes only. Mutual funds may purchase and sell securities at any time and securities held by a fund may increase or decrease in value. Past investment performance of a mutual fund or individual security may not be repeated. Statements that pertain to the future represent the portfolio manager’s current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein. Trademarks displayed herein that are not owned by Industrial Alliance Insurance and Financial Services Inc. are the property of and trademarked by the corresponding company and are used for illustrative purposes only. The iA Clarington Funds are managed by IA Clarington Investments Inc. iA Clarington and the iA Clarington logo are trademarks of Industrial Alliance Insurance and Financial Services Inc. and are used under license.