Deciding how to hedge interest rate risk begins with a personal assessment: what kind of fixed income investor are you?
The Federal Reserve may not have raised rates this month as many had anticipated, but, by and large, most economists and market experts say rates are headed higher, and sooner rather than later. If the era of post-financial-crisis, ultra-low rates is indeed coming to an end, managing that transition to higher rates is imperative.
But how does an investor know what to do? Fortunately, there are different ways to manage a portfolio in a rising-interest-rate environment. It’s not just about reducing interest-rate risk and duration, it’s about sticking to what you are trying to achieve in your overall portfolio.
Different people have different risk tolerances, and they want different things out of their fixed-income allocation. Some turn to fixed income merely for diversification; some hunt for yield; some just want predictability of income at the end of the road.
So the question is, what kind of fixed-income investor are you?
We outline below five broad groups of investors, and the solutions that may apply to them.
1. The Diversifier
“If there’s someone who looks at fixed income as ballast to their portfolio, a ballast against equities, they may not want to reduce interest-rate risk at all,” Matt Tucker, head of fixed income for iShares, told ETF.com.
The reason for that, he says, is due to the historical low or negative correlation between stocks and bonds. To many, fixed income is a diversifier to equity exposure, and a lot of that diversification benefit comes from the interest-rate risk that bonds have.
“A typical investor who is investing in a fund such as the iShares Core U.S. Aggregate Bond ETF (AGG | A-98) may want to hold on to that investment, because even in a rising-rate environment, they are going to get the diversification benefits of that exposure,” Tucker said.
“Timing a rising-rate environment is very difficult,” he added. “For the investor who is long-term-minded and looks at fixed income as a diversifier, they should be comfortable leaving that allocation as it is.”