Five tools to manage interest-rate risk

Fixed-income investors have a handful of tools to navigate the expected bumpy road ahead, says Terry Moore, vice-president of T. Rowe Price Group Inc., and portfolio specialist in the company’s fixed-income division.

In an industry whitepaper, Moore and his team recently defined five ways for bond investors to manage anticipated interest-rate risk.

He said the tools — structural curve positioning, selective regional and sector allocation, holding euro-dominated credit, holding short-maturity bonds, and duration management — will be particularly useful toward year’s end.

“We expect the road to get a little bumpier because central banks are going to start moving some accommodation,” he said. “There’s still some lingering questions around the Delta variant and reopening of economies. So, we just want to increase liquidity in the portfolio, to be ready to take advantage of any minor sell-offs that may occur as volatility increases.”

He suggested structural curve positioning could involve the implementation of “curve steepeners” like underweighting, or even shorting bonds as the economy normalizes, which will benefit the investor if longer-term interest rates rise faster than shorter-term rates.

As for allocating across regions and sectors, Moore said investors can overcome a natural home bias to take advantage of opportunities.

“There’s several places around the world that can offer quality and yield and have less correlation to what local Canadian interest rates are doing,” he said. For example, there are deals to be found among Asian investment-grade issues.

“The same thing goes for emerging market corporates, which may sound risky, but on average that sector is investment grade,” he added. “It’s now [a] $2-trillion sector, which is larger than the U.S. high-yield sector.”

Moore said the European Central Bank is likely to hold interest rates lower for longer than most global central banks, given structural issues and local demographics.

“What this means is that the euro credit bonds will not face the same duration risk that North American credit may face when the Fed or the Bank of Canada begin to hike rates,” he said. “So, by buying euro credit, you may not face the same headwind that you might have in the U.S. or Canada.”

The fourth tool — buying shorter-duration bonds — may seem obvious, as such bonds are exposed to less interest rate risk. “However, the challenge with that is that it usually means less yield,” Moore said.

The solution for institutional investors is to combine those investments with a derivative overlay or credit default swap.

“This allows the investor to gain exposure to the spread advantage of the credit market, but without the interest rate risk. Now of course there’s going to be credit risk, but you’re going to have that with any bond. But it’s a way to boost the return of a shorter-duration maturity bond.”

Perhaps the simplest of the five tools is to actively manage bond duration.

“That’s either through the bond selection,” Moore said, “or through liquid interest rate hedges to target specific parts of the yield curve.”

Duration can sometimes have a greater impact on returns than credit, he said, particularly in periods like now when credit fundamentals are strong, balance sheets are in good shape for both the business and consumer, and there are no imminent risks for recession or default in the near future.

“As bond investors, we’ve enjoyed a 40-year rally as interest rates have steadily declined to historic lows. Now we’ve likely reached the bottom,” he said. “As we eventually get Covid under control, children go back to school, people go back to work [and] economies reopen, interest rates, which are a component of growth and inflation, are going to likely head higher.”

Moore also suggested a barbell-shaped investment strategy, heavily weighting high-quality bonds like U.S. agency mortgage-backed securities on one side, and lower-quality offerings like high-yield bonds and bank loans below investment grade on the other side — with a smattering of mid-quality products like investment-grade corporates between them.

“Given how rich valuations are, generally speaking, increasing liquidity in the portfolio [and] increasing the quality doesn’t cost too much in terms of opportunity cost,” he said.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.