May has been a month of change in the bond market as the
CBOE Interest Rate 10-Year T-Note
(INDEXCBOE:TNX) has rocketed from a low of 1.6% earlier in the
month to a new breakout high of over 2.1%. To put it in percentage
terms, the benchmark index has risen over 25% just this month
alone. That is a tremendous jump that has been fueled by recent
Federal Reserve comments
that signal a possible tapering of its bond purchasing program. In
addition, we have seen the stock market continue its relentless
climb, which has been a catalyst for money coming out of bonds and
into hot sectors of the market like financials and health care.
The question on everyone's mind is: Does this breakout in yields
signal a new trend change, or will the cycle reverse so that we see
a flight to quality in bonds?
I believe that the overriding factor in this debate will be whether
or not the stock market can continue to push to new highs. If
stocks remain resilient, then we will most likely continue to see
yields climb to the next area of resistance at approximately 2.4%.
However, if stocks roll over and we see a return of volatility in
equities, then we will most likely see money coming back into the
safety of fixed income.
I am more inclined to favor at least a moderate correction in
stocks in the short term, which would be a positive for bond
holders. That being said, if you are overweight fixed income in
your portfolio, there are still several actions that you can take
to reduce your exposure to rising interest rates and cushion your
portfolio against inflationary forces.
The easiest way to reduce your portfolio's sensitivity to interest
rates is to lower the average duration of your holdings. For
example if you are holding the
iShares Investment Grade Corporate Bond ETF
(NYSEARCA:LQD), you may want to consider switching to the
Vanguard Short-Term Corporate Bond Fund
). This switch will not change the overall credit quality of your
portfolio, but you will be drastically shortening your average
duration from 11.82 to 3.1 years. The drawback is a lower yield.
However, that tradeoff can be quickly mitigated by much smaller
price fluctuations in a rising interest rate environment.
Another way to combat the effects of rising interest rates is to
consider allocating a portion of your portfolio to floating rate
notes. Two of the biggest
in this sector of the bond market are the
iShares Floating Rate Note ETF
(NYSEARCA:FLOT) and the
PowerShares Senior Loan Portfolio
(NYSEARCA:BKLN). Floating rate notes have historically performed
well in a rising interest rate environment because their coupons
fluctuate based on the prevailing market rate. This unique feature
helps to mitigate the duration risk that is associated with
traditional fixed-rate bonds. FLOT invests primarily in investment
grade notes centered on the financial sector, while BKLN invests in
securities of lower credit quality with higher yields.
Lastly, investors who are looking to hedge their fixed income
portfolio may want to consider a small allocation to a rising rate
fund such as the
ProShares Short 20+ Year Treasury Bond Fund
(NYSEARCA:TBF) or the
ProShares Short 7-10 Year Treasury Bond Fund
(NYSEARCA:TBX). These ETFs give you inverse exposure to long-term
and intermediate-term Treasury bond prices, respectively. In my
opinion, inverse ETFs should only be used as short-term trading
vehicles in order to hedge a long position or take advantage of a
dislocation in the market.
If you have already experienced the brunt of the recent interest
rate rise, you may consider looking at reducing your equity
exposure or using surplus cash to buy fixed income
opportunistically as rates become more attractive. In addition, if
you already have a low-duration bond portfolio, you might look to
elongate duration at low-risk entry points to take advantage of
higher yields and the potential for capital appreciation.
No matter how you decide to adjust your income portfolio to take
advantage of the changes in the current interest rate environment,
be mindful of the risks. I recommend you develop a
to strategically shift your portfolio to benefit from these
changes. Making subtle changes now can pay huge dividends down the
road when the Fed starts to tighten its purse strings.
Read more from David Fabian, Managing Partner at Fabian Capital
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