Sunday, August 30 , 2015, 8:14 am | Fair 76.0º




Craig Allen: What Investors Should Consider in a Rising Interest-Rate Environment

Shorter maturities provide crucial flexibility for future reinvestment, when the time comes

By Craig Allen, Noozhawk Business Columnist | @MPAMCraig |

Fixed-income investors are facing a dilemma. With interest rates about to embark on what appears to be a rising rate cycle, what should the fixed-income investor do to maintain his or her income stream, while at the same time, protect the principal? This has always been a challenge in a rising interest-rate environment, and today, investors face a particularly acute problem. The good news is there are strategies that one may employ to address this issue. The bad news is there are tradeoffs that one must accept with each strategy. There’s no free lunch.

An investor could invest all of his or her fixed-income assets in short-term bonds. Let’s say Treasury notes with a five-year maturity. This would give the investor some flexibility in that, at the end of a relatively short time period (five years), the bonds would mature and the investor could then reinvest the entire value of his or her fixed-income portfolio into an investment that would, in theory, have a higher rate of return (if we assume that interest rates have indeed risen over that five-year period). This approach would allow the investor the flexibility to reinvest sooner, at the expense of locking in a higher yield available on longer maturity investments (say, a 10-year bond of the same type, such as a Treasury bond with 10-year maturity).

If the investor decided to lock in the longer-term yield of the 10-year Treasury, instead of investing in the five-year notes, the investor would receive a higher yield on the portfolio. But, this higher yield would come at the expense of the flexibility to reinvest after only five years, as would be the case with the five-year note portfolio. So, one can see that there is a tradeoff between flexibility and yield.

One strategy that historically has been used by professionals and individuals alike is to build what is called a laddered bond portfolio. The term ladder refers to spacing or laddering bond maturities over some number of years to produce the desired overall portfolio characteristics. As an example, one might buy, in equal portions, $200,000 of each maturity, starting with a five-year bond, and ending with a nine-year bond. The portfolio would look like this:

Maturity                     $ Invested           Yield                     $ Income
5-Year                     200,000.00                     1.00%                    2,000.00
6-Year                     200,000.00                     1.25%                    2,500.00
7-Year                     200,000.00                     1.50%                    3,000.00
8-Year                     200,000.00                     1.75%                    3,500.00
9-Year                     200,000.00                     2.00%                    4,000.00
Totals                     1,000,000.00                     1.50%                    15,000.00

(This example is purely hypothetical, and does not represent actual returns or available yields, and is intended solely for the purpose of illustration.)

There are several key benefits to this strategy. For example, the investor would receive an average rate of return (averaged over the total funds invested), which would be higher than if the investor had simply invested the entire portfolio in the shortest maturity (although having less flexibility than if the investor had invested the entire portfolio in the shortest maturity). Also, the investor maintains significantly more flexibility with this strategy compared to investing all funds in the longest maturity (although with a lower overall yield than if the investor had invested all funds in the longest maturity).

One can see that the laddered portfolio is a strategy that encompasses a nice compromise between total return and flexibility. A laddered portfolio can be constructed in many different configurations to suit almost any investor’s needs. One can choose to construct a laddered portfolio with one-year, two-year and three-year bonds if one feels that rates will rise more significantly in the shorter term. If rates rise during the next three years to acceptable levels, the investor could reinvest the funds as the bonds mature into bonds of longer maturities to increase the overall yield of the portfolio. For example, let’s say rates are at the following levels today:

1-year Treasury                     0.25%
2-year Treasury                     0.35%
3-year Treasury                     0.45%

8-year Treasury                     1.75%
9-year Treasury                     2.0%
10-year Treasury                     2.3%

An investor might construct a laddered bond portfolio with the following dollar amounts in each of three maturities.

1-year Treasury:                    $400,000 @ 0.25%
2-year Treasury:                    $300,000 @ 0.35%
3-year Treasury:                    $300,000 @ 0.45%

After the first year, the one-year Treasury initially purchased would mature, so the investor could reinvest the $400,000 at the then-current rate on the one-year Treasury. We can further assume that at the end of year two, the one-year Treasury yield has again increased in yield, and that the investor would reinvest the proceeds from the one-year Treasury into the current one-year Treasury, for another year.

The two-year Teasury would mature at the end of year two. If we assume that the rate on two-year Treasuries has also risen, we can assume that the investor will reinvest the proceeds from the maturing two-year Treasury at the beginning of year three. For this example, we are assuming that the investor is expecting rates to peak at the end of year three, so this investor would only want to tie up the proceeds from the maturing two-year Treasury for one more year. This investor would therefore take those proceeds and reinvest them into a one-year Treasury at the beginning of year three.

Let us further assume that rates rise significantly over the three-year period so that yields have moved to the following levels by the end of year three:

1-year Treasury                     1.00%
2-year Treasury                     1.50%
3-year Treasury                     2.00%
8-year Treasury                     4.00%
9-year Treasury                     4.50%
10-year Treasury                     5.00%
15-year Treasury                     6.00%
20-year Treasury                     7.00%

If the investor believes rates will not go significantly higher, he or she would want to extend maturities, possibly using the 10-, 15- and 20-year Treasuries in the ladder:

10-year Treasury:                    $400,000 @ 5.00%
15-year Treasury:                    $300,000 @ 6.00%
20-year Treasury:                    $300,000 @ 7.00%

In this manner, the investor can manage the average yield of his or her overall portfolio by evaluating the available yields on fixed-income investments at the time that bonds mature, and choosing the bond that appears to have the best characteristics, keeping in mind the investor’s expectations for the direction of interest rates. (If the investor does not feel comfortable making these judgments, the investor should seek the advice of a qualified investment professional.)

Laddered portfolios can be constructed with any type of bond or other fixed-income vehicle, and in any number of maturities and weightings. The key with this strategy is to balance the investor’s need for current income with overall investment objectives and risk tolerance to arrive at the best compromise and combination of investment vehicles and maturities. There are certainly other strategies for generating current income that may be appropriate for investors. Each investor must evaluate all available options and determine the best mix of investments for their portfolio.

With the recent jump in rates, especially for longer maturities, that we witnessed over the past few weeks, (the 10-year Treasury ran from a yield below 2 percent to above 2.3 percent in just a few weeks), investors should see the writing on the wall: Interest rates are headed higher, significantly higher, in the near future. In a rising-rate environment, investors should keep maturities shorter so they will have the flexibility to reinvest at higher rates in the future, rather than tying up their funds in long maturities at historically low interest-rate levels.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.




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