Playing Defense with Bond Strategy

First Republic Investment Management
April 29, 2015

In today’s bond market, common investor sentiment is that interest rates are going higher and prices will fall. While the statement is likely true, the price-yield relationship of bonds should not paralyze investors from including bonds as part of their overall investment strategy. 

Defense in bonds can take many forms, but two widely used techniques are duration and structure. Duration is one measure of a portfolio’s market risk for a given rise in interest rates. When thinking about duration, a general rule of thumb can be applied: Given an overnight rise or fall of 1% in interest rates, market value will fluctuate up or down by approximately the duration expressed as a percentage. So if five-year interest rates go down or up by 1% overnight, a portfolio with a five-year duration would be expected to see market value rise or fall by about 5%.   

Dramatic moves of 1% overnight are extremely rare in the U.S. bond market. The “taper tantrum” of 2013 saw 10-year bond yields rise by 1.11% in a little more than 60 days. This “tantrum” was a very large move over a short period of time, but a properly structured bond portfolio is able to take advantage when markets move.  

Structure involves how a portfolio is positioned along the yield curve. For example, a “barbell” structure would include a blend of long and short maturities but few if any intermediate bonds. Individual bonds also have important structural considerations, including coupon, call optionality and credit quality. Used in combination, such as a floating-rate bond within a barbell portfolio, structure helps reduce losses due to unexpected market movement. 

Opportunity Cost

Sitting in cash and waiting is a suboptimal strategy. Short-term interest rates have been at or near zero since the fourth quarter of 2008. Using seven-year U.S. Treasuries as a low-risk proxy, the opportunity cost of sitting in cash versus low-risk Treasuries was about 2.10% per year on average since the end of 2008. Buying and holding to maturity would place the investor about 12.6% better off today, a hefty lost opportunity versus waiting in cash. 

Planning for Change

Nobody really knows when interest rates will rise — or, when they do, how far they may go. But positioning a portfolio defensively with structure and a targeted duration is one way to guard against that uncertainty. When interest rates do rise, techniques can be employed to reduce taxes while restructuring the portfolio to the new environment. For example, a tax-loss swap can be executed, where an investor sells a bond yielding 2% for a loss and buys a similar (but not identical) bond that yields 3% in the current market. Without materially affecting portfolio structure, the investor would gain 1% in yield and bank a tax loss to offset capital gains generated elsewhere in the portfolio. 

One of the great things about the bond market is that there are portfolio structure and investment combinations fit for nearly every interest rate environment. Above all, the important thing is to work with your investment advisor to ensure a plan is in place to ensure your portfolio is continually positioned to meet your key investment goals. 

This article is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein. 
All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities, and the client's expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results.
Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. 
The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that First Republic (or FRIM) does not provide tax advice. The levels and bases of taxation can change. Investors' tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document.