Don't Gamble With Interest Rates

Your fixed-income portfolio needs to work for you for a long time, so the decisions you make today should reflect a long-term perspective. If you simply react to short-term market changes with no regard for a long-term strategy, you could compromise the success of your financial goals.

Avoid Defensive Measures during Volatility
During volatile markets when the future direction of interest rates may be uncertain, you may be tempted to take a more defensive investment posture. For many investors this means putting a greater proportion of their long-term fixed-income investments into cash, cash equivalents and short-term fixed-income investments, including certificates of deposit (CDs). Unfortunately, increased dependence on these types of investments generally reduces the effectiveness of your portfolio to maintain a more stable income stream. We call them variable-income investments because the rates they offer can change suddenly, and quite frequently, which can cause your income to decline substantially.

In fact, while you may think this strategy is interest rate neutral, it’s actually an implicit bet that interest rates are going to rise. That’s because should interest rates fall, your income would decline as those rates decrease.

Perhaps you believe that inflation pressures will likely push rates higher, so you want to “park” your funds in cash equivalents until rates inevitably rise. This can be a dangerous gamble. It may be tempting at times to base your investment decisions on what direction you think interest rates are headed. However, with so many diverse factors impacting interest rate movements, even seasoned professionals are wrong more often than not. As a result, a strategy based on the direction of interest rates can set you up for failure.

A Better Strategy
Laddering the maturities of your fixed-income investments is a more interest rate-neutral strategy that does not depend on rates rising or falling for success. By laddering, you are more insulated from inaccurate interest rate forecasts. If interest rates fall, rates of the majority of investments in a laddered portfolio are still locked in, helping to keep portfolio income more stable. On the other hand, should rates rise, funds are regularly available to take advantage of the higher rates, since investments in the ladder will mature periodically.

Consider Call Protection
Of course, when laddering your fixed-income portfolio, it is important to consider the call protection of your bonds. If all of your investments are callable at about the same time, there is a risk that they could all be called or redeemed during a period of declining interest rates. In that case, the ladder would not do a very good job of maintaining a steady stream of income for the portfolio. Therefore, you need to strive to have some variety in the call protection of the callable bonds that are included in any fixed-income ladder.

It’s easy to get caught up with the current headlines concerning interest rates and get distracted from your long-term investment strategy. But like other investments, bonds require a long-term perspective in order to maximize the benefits you hope to receive in the long run. Contact your financial advisor about a complimentary portfolio review to ensure your fixed-income portfolio has a proper ladder.

Mario D. De Rose, CFA
Fixed Income Strategist