Managing Interest Rate Risk in Fixed Income Portfolios
June 30, 2013 | Topics: Alternatives
- For the past 30 years, fixed income performance has been boosted by bond prices increasing as interest rates fell
- With rates now at historic lows, investors are at risk of taking losses if rates start to rise
- A long/short strategy can help investors manage interest rate risk within their portfolios, potentially limiting the effects of rising rates
Falling Interest Rates Have Led to Sizable Returns in Fixed Income
Fixed income has long been a staple of investors' portfolios, typically providing both income and capital appreciation. This has worked out very well recently, with a conventional fixed income portfolio returning over 6% a year since 2001. An overwhelming portion of these fixed income returns has come from fixed income yields decreasing and bond prices rising. This inverse relationship is known as interest rate, or duration, risk. Nearly 90% of conventional fixed income returns were generated from this interest rate risk.
Interest Rates are Low, Leaving Investors at Risk if Interest Rates Rise
With interest rates at historic lows, there is not much room for interest rates to fall further. This puts investors at a significant risk, because as interest rates rise, the price of an investor's bonds will fall, eating away most, if not all, of the portfolio's returns. Even if interest rates only move up 1%, there can be dramatic effects for investors.
A Long/Short Strategy can Protect Investors' Portfolios from Rising Interest Rates
Adding a long/short strategy to a fixed income portfolio can help an investor manage their interest rate risk, potentially limiting the losses resulting from rates moving upward. Since the fund manager can go both long and short, the fund can be managed to a zero exposure to interest rates. This means that the strategy could see minimal losses as rates increase.
By having little interest rate risk, returns for a long/short credit fund are generated largely out of buying bonds of strong borrowers and shorting bonds of poor borrowers. While a fixed income long/short strategy presents the opportunity for significant losses, including, in some cases, losses which exceed principal invested, investors can now potentially profit from both positive and negative views on individual credit securities rather than relying on the benefits of falling interest rates. Also, with a long/short strategy being able to be net long, market neutral, or net short, the investor also can capitalize on broad market moves as they see fit. The flexibility afforded by a long/short strategy can lead to decreased correlation to broader markets and lower volatility.
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Incorporating alternative investments into a portfolio presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors.
Investing in alternative strategies such as a long/short strategy, presents the opportunity for losses which exceed the principal amount invested. There is also the possibility that long and short strategies could both fail, thereby increasing volatility and potential losses.
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