We know there is little evidence that interest rates are going to rise soon in most other parts of the world, but the situation in the United States remains of critical interest to global investors, as both a bellwether and a blueprint because even in those economies with falling or stubbornly low rates, the situation is likely to change at some point in the future.
In the United States, the fixed income story today is a cautionary tale of rising interest rates lurking around the corner. Most investors probably have heard this story for a while now, surmising that the end of the bond bull market will mean it is game over for their fixed income portfolios. Franklin Templeton’s Eric Takaha doesn’t see that as a foregone conclusion, but also believes plotting a fixed income strategy to meet tomorrow’s challenges requires a willingness to think about investing in the sector a little differently, perhaps looking beyond traditional borders, benchmarks and duration models, and seeking out strategies that have the potential to provide what could be considered a natural hedge against interest-rate risk.
Eric Takaha, CFA
Portfolio Manager, Senior Vice President
Director of the Corporate & High Yield Group
Franklin Templeton Fixed Income Group
Diversifying Beyond Core Fixed Income
Do rising US interest rates mean investing in bonds or bond funds is destined to become a losing proposition? That the “bond bubble” that some say has been building for decades is set to burst? While we do not know the exact timing around future interest-rate moves, we think investors should consider managing their fixed income portfolios with a defensive posture—one that can not only potentially generate income, but also aims to position for the least-nausea-inducing ride. In our view, part and parcel of that approach should look beyond the US interest rate curve,1 aiming to provide income generation and potential return across a broad range of fixed income markets globally.
We believe that in the decade ahead, the strategies that have relied on falling interest rates to generate returns could be challenged. For that reason, we think investors should think about diversifying beyond core fixed income in their portfolios—looking beyond the US rate curve to provide potential income and return across a broad range of global fixed income markets—but also be keenly focused on building and evolving a dynamic risk-management strategy.
Finding the “True Risk” in a Portfolio: An Inexact Science
We believe there is growing recognition among the investment community that risk is a primary lever in the investment process. While effective modeling is built on a foundation of transparency, no single measure—including the concepts discussed here—will provide a complete picture of the “true” risk inherent in any individual investment or portfolio. Risk professionals must look at a wide variety of data points from a host of sources and risk measures.
When discussing interest-rate risk, the conversation often turns to duration. An examination of duration (see sidebar), which takes into account bond maturity, coupon and call features, can offer a mechanism to help manage the risk—and the volatility—in fixed income investments that accompany interest-rate movements. For example, maintaining a shorter duration in a portfolio tends to result in lower interest-rate-related volatility.
We view traditional core and passive fixed income strategies with concentrated duration exposure as likely ill-suited to succeed in coming years. In our view, a truly unconstrained strategy has more flexibility to potentially navigate and exploit varying market conditions and diversify the drivers of return in a portfolio. This result becomes more apparent when compared with relatively duration-heavy core fixed income portfolios, particularly in a rising-rate environment.
Various fixed income indexes and US Treasuries have experienced relatively strong correlations (see table below), indicating that duration has been the predominant risk, and yield movements have been the primary driver of returns. Conversely, a strategy with relatively low correlation—and even a negative correlation—to US Treasuries historically could be a more efficient allocation to fixed income. The table below shows how cross correlations across the fixed income market can potentially enhance diversification—without guaranteeing of profits or protection against risk of loss—in an unconstrained portfolio that has the ability to exploit these different sectors.
Duration and Risk: Thinking Empirically
While interest-rate movements drive a meaningful portion of fixed income returns, there are other factors, including credit spreads and currency movements, among others, that also drive returns.
If a rise in interest rates is anticipated, maintaining a low or negative duration might be considered to seek to avoid potential portfolio losses due to a drop in bond values. Negative duration may seem highly desirable in a rising-rate environment, but it can result in undesirable levels of volatility and risk. And, while the value of a portfolio with negative duration might increase when rates rise, there is the possibility rates may remain steady or even fall, resulting in potential loss. Our goal is to have a complete understanding of the interest-rate risk in our portfolio and position based on our views across a variety of markets and sectors. To review a portfolio’s sensitivity to interest-rate risk, we believe an examination of empirical duration—calculating duration based on historical data over a specified time period—is a worthwhile exercise.
We cannot completely remove the risk elements, but we can try to influence the interest-rate experience of a portfolio. Our approach to risk management is three-pronged: It involves recognizing the risks we are taking, making sure they are rational, and determining that there is appropriate reward potential.
In a portfolio comprising highly duration-sensitive assets, yield curve movements will dominate performance. However, there are other potential drivers of performance in a flexible, unconstrained fixed income portfolio—including various spread sector and global exposures. By expanding into these sectors, we aim to reduce the reliance on interest rates as a driver of performance. The primary performance drivers in our strategy are sector allocations and rotation decisions, along with security selection within those sectors. So, we examine empirical duration not necessarily as a primary performance driver, but as part of our overall risk-management toolkit.
Certain bonds have pricing that tends to be impacted more significantly by factors other than changes in interest rates, such as economic growth, corporate earnings patterns and temporary market shocks. This is particularly true for more credit-oriented sectors. Rising interest rates tend to accompany healthy economic growth, and when growth is healthy in an economy, corporate assets are generally supported.
Putting It into Practice
So what does this all mean in terms of portfolio positioning? Our team’s goal is to build a well-diversified portfolio that has a variety of performance drivers beyond interest-rate movements, investing in both US and foreign debt securities.
From a portfolio-duration-positioning standpoint, incorporating a view of empirical duration alongside model-based durations (such as Option Adjusted Duration) can help provide a more complete picture. Additionally, as mentioned, our unconstrained approach allows us to look across a broad range of credit markets globally for potential income and return, regardless of interest-rate movements in one particular market.
While many US investors seem to be so singularly focused on the impact of rising rates—to the point of panic in some cases—they fail to examine what has actually happened to various fixed income investments over similar periods historically. We have found that historically over time, interest-rate moves do not often play as large of a role in a broadly diversified fixed income portfolio as one might think.
The impact of rising rates on a fixed income portfolio (for better or worse) ultimately depends on what asset classes and market segments one is invested in. It is also worth pointing out the importance of the “income” component within fixed income—the primary attraction for many investors to the asset class—that we think can be achieved using myriad tools and market exposures. We believe what it takes is a broad view of the sectors that comes from a truly unconstrained approach. And, we think it requires a thoughtful examination of the risks, one that looks at risk modeling through a variety of different lenses.
Eric Takaha on:
US ECONOMIC GROWTH
When we evaluate the fundamentals in the US economy, we see a fairly constructive environment. It appears the United States is finally moving toward more trend-like growth of around 3% in 2015–2016, following the more sluggish pace of economic growth in the wake of the 2007–2009 financial crisis. This growth is due to a continued improvement in the consumer, corporate and housing sectors. In our view, the US economic picture remains relatively upbeat compared to other parts of the globe that are confronting somewhat more challenging conditions.
Many Americans are feeling a “wealth effect” that comes not just from rising prices for real estate and financial investments but also, and more immediately, from the sharp drop in oil prices in late 2014. The combination of these factors, along with strong jobs growth could, we think, spark an increase in consumer demand ahead.
US INTEREST RATES
While we cannot predict the exact timing of interest-rate moves, we would expect to see future Federal Reserve (Fed) interest-rate increases as gradual and measured. Given market expectations for higher US rates going forward, we think a more limited exposure to the US Treasury curve could be a prudent move in the current environment.
Thinking about corporate credit in 2015, the strong US dollar and weakness in commodity prices may put some pressure on first-half 2015 earnings, and many companies are becoming a bit more aggressive with their balance sheets and more willing to take on more debt. Over the last several years, in general, US companies have been able to refinance at lower rates, so their interest costs have remained low. However, we think that effect may start to change if and when the Fed begins to raise short-term rates. Overall though, the proportion of companies in the market that is considered distressed remains very low, the default rate has remained below longer-term averages, and liquidity levels appear generally adequate, in our view. As a result, we have tended to view pullbacks as potential buying opportunities. That said, prolonged lower commodity prices could challenge certain issuers and cause distress in related sectors, although at this time, many issuers in these industries seem to have liquidity to weather some period of lower commodity prices, and we think valuations have largely priced in this risk.
The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.
Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in a portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in a portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in a loss of principal—a risk that may be heightened in a slowing economy. The risks of foreign securities include currency fluctuations and political uncertainty. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and less liquidity. Investing in derivative securities and the use of foreign currency techniques involve special risks and, as such, may not achieve the anticipated benefits and/or may result in losses.
1. An interest rate curve is a graphical representation of interest rates at a set point in time of bonds having equal credit quality but differing maturity dates, such as US Treasury securities. It is generally seen as a benchmark for market interest rates.