Wednesday, 9 December 2015

3 strategies for preparing your bond portfolio for a rate hike

With only a few days left until the Federal Reserve’s December meeting, an interest-rate hike seems to be a foregone conclusion for the market, with bond investors bracing for a rise in the Fed-funds rate.
Bonds, seen as a safer alternative to stocks, aren’t looking so safe right now. The market views a December rate hike as a near certainty, and that view has pushed short-term Treasury yields toward their highest levels in 5½ years. Treasury yields rise when prices fall and vice versa.
Fixed-income strategists have warned that a rate hike could send short-term yields even higher, as short-term interest rates tend to spike because they are most vulnerable to changes in the Fed-funds rate.
Indeed, on Tuesday, the two-year benchmark yield TMUBMUSD02Y, +1.72% was trading near 5½ year highs, the one-month Treasury bill TMUBMUSD01M, -3.70%  yield hit an intraday high of 2½ years and the an auction of three-year Treasury notes TMUBMUSD03Y, +3.10%  closed at their highest yield since 2011.
Here are some ways experts say you can prepare your bond portfolio for a rate hike.
The barbell
This strategy focuses on taking advantage of the shape of the yield curve and avoiding the parts that experience the most volatility after a rate hike, said Jack Flaherty, co-portfolio manager at money manager GAM.
The “barbell” term is derived from the fact that this investing strategy looks like a barbell, heavily weighted at both ends — representing short-and long-term Treasurys — with nothing in between.
This “in between” is known as the belly of the yield curve, which includes medium-term maturities typically seeing most volatility after a rate hike.
Here is why: After a rate hike, short-term yields typically rise and the spread, or difference, in yield between short and long-term maturities shrinks. That’s when the yield curve is said to flatten.
In a flattening scenario, the belly of the curve sees the most volatility. So, a strategy to minimize volatility involves balancing a portfolio between short and long-term holdings and eliminating the medium-term maturities around five years — i.e. ditching the belly.
Here’s an explanation of how traders typically trade in the so-called belly of the yield curve.
Long for longer
If the Fed hikes rates, intermediate- to long-term bonds may actually rally, driving prices higher and yields lower.
A rate hike by the Fed amid “relatively slow U.S. growth, limited inflation pressure and solid structural demand for longer-term high-quality bonds implies, in our view, that shorter rates will rise faster than long-term rates,” according to a Monday research report from U.S. Bank Wealth Management.
Fed rate hikes tend to have little influence on long-term rates, except through inflation expectations, according to the report. In the 1999 and 2004 hiking cycles long-term yields rose in the short term but eventually fell again.
That means investors could benefit from allocating more weight in their bond portfolio to long-term Treasurys, such as the 10-year note TMUBMUSD10Y, +1.74%  and the 30-year bond, known as the long bond TMUBMUSD30Y, +1.59%
The ladder
Another way to build a low-risk portfolio in a rising-rate environment is the so-called ladder. This strategy is best for investors with a long horizon who don’t want to play the game of waiting to see when and at what pace rates will rise.
This strategy involves staggering the bonds so the maturities are equally divided.
A five-year ladder, for example, might have 20% of the bonds mature every year or 10% of the bonds mature every six months over the next five years. Bonds that mature get reinvested, taking advantage of potential rising rates.
Taking advantage of the full spectrum of maturities in the Treasury market can prove useful as the sovereign bond market — once considered among the safest investments — has recently experienced bouts of increased volatility due to diverging central bank policies across the globe, said Sharon Stark, fixed-income strategist with D.A. Davidson & Co.
Last week, for instance, the 10-year Treasury benchmark yield posted its biggest one-day gain in 2½ years, in a sharp government-bond selloff after the European Central Bank’s monetary stimulus measures fell short of expectations.

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