Sunday, March 29, 2015

High Yield Bonds in Rising Interest Rate Environments

As the Fed moves closer to the inevitable rise in interest rates, one's bond portfolio construction and bond portfolio duration should be examined. Portfolio duration (similar to maturity) needs to be examined due to the fact that generally, the longer the maturity a bond has, the more the bond suffers in price when rates rise. A 25 or 30 year maturity coupon bond may fall 15% or more in price with a 1% rise in rates. A 30 year maturity, zero coupon bond could fall 30% in price with the same 1% rise in rates.

Are there bonds that maintain their price in rising environments? Or, better yet, are there bonds that rise in price slightly when rates rise? The answer is yes. First, there are adjustable-rate bonds that are available. Most people are familiar with adjustable rate mortgages...these are similar. The interest rate on an adjustable rate bond is dependent upon some interest rate index. As that index rate rises, the bond's interest rate rises, often raising the price of the bond.

The second group of bonds that tend to rise in price with a rise in interest rates are high yield bonds. Because high yield bonds are so dependent upon a good economy, and because a good economy also tends to cause the Fed to raise rates, these bonds often maintain or even increase their value in a slowly rising interest rate environment. We don't advocate overallocation, but we definitely recommend some allocation of a bond portfolio to high yield bonds.

There is no way to remove volatility entirely from a portfolio, but with careful consideration, one can at least mitigate some of that volatility.

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