Five tools for managing interest rate risk

Fixed income investors have a handful of tools to navigate the expected bumpy road, says Terry Moore, vice president of T. Rowe Price Group Inc. and portfolio specialist in the fixed income division of the society.

In a white paper on the industry, Moore and his team recently outlined five ways for bond investors to manage forward interest rate risk.

He said the tools – structural curve positioning, selective regional and sector allocation, euro-dominated credit holding, short-term bond holding and duration management – will be especially useful towards the end of the year. year.

“We expect the road to be a bit more bumpy because central banks will start to move accommodations,” he said. “There are still lingering questions around the Delta variant and the reopening of economies. So we just want to increase the liquidity of the portfolio, to be prepared to take advantage of any minor sell-off that may arise as volatility increases. “

He suggested that structural curve positioning could involve implementing “curve slopes” like underweighting, or even shorting bonds as the economy normalizes, which will benefit the economy. the investor if long-term interest rates rise faster than short-term rates.

Regarding the distribution across regions and sectors, Moore said investors can overcome a natural bias to take advantage of opportunities.

“There are several places in the world that can offer quality and yield and that have less correlation with local Canadian interest rates,” he said. For example, there are transactions among Asian investment grade issues.

“The same goes for companies in emerging markets, which may sound risky, but on average this sector is investment grade,” he added. “The snow [a] $ 2 trillion sector, which is larger than the US high-yield sector. “

Moore said the European Central Bank would likely keep interest rates lower for longer than most of the world’s central banks, given structural issues and local demographics.

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

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

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

“This allows the investor to gain exposure to the credit market spread advantage, but without the interest rate risk. Now, of course, there is going to be a credit risk, but you are going to have it with any bond. But it’s a way to increase the yield on a shorter bond.

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

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

Duration can sometimes have a bigger impact on returns than credit, he said, especially in times like now when credit fundamentals are strong, balance sheets are healthy for both companies. and consumers, and there is no imminent risk of recession or default. the near future.

“As bond investors, we have experienced a 40-year rally as interest rates have steadily fallen to historic lows. Now we’ve probably hit rock bottom, ”he said. ‘As we come to get Covid under control, kids are going back to school, people are going back to work [and] as economies reopen, interest rates, which are a component of growth and inflation, are likely to rise. “

Moore also suggested a dumbbell-shaped investment strategy, heavily weighting high-quality bonds like US agency mortgage-backed securities on one side, and lower quality offerings like high-grade bonds. yield and investment grade bank loans on the other hand – with a handful of medium grade products like investment grade companies among them.

“Given the wealth of valuations, in general, the liquidity of the portfolio increases [and] increasing the quality does not 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 the contribution of the sponsor.

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