Five Steps We Take to Manage Your Fixed Income Investments When Interest Rates Rise

Eric Jussaume

Eric Jussaume

August 6, 2018

Investing & Economy

Whenever the Federal Reserve raises the interest rate, the effect ripples through the economy—touching the stock and bond markets, local and national banks, credit unions, mortgage brokers, finance companies, insurance companies, credit card issuers—and eventually landing on your personal balance sheet.
On the positive side, a higher interest rate means you have the potential to:
  • earn higher interest on any money you keep in a savings account or a money market fund, and
  • reinvest the short-term securities you hold in your investment portfolio at higher rates as they mature.
But higher rates also mean you’ll pay more to finance a new car, home, or business. If you have variable rate installment loans, that interest rate is going to increase too, especially if it’s based on a percentage or “spread” over prime. If you’re in an adjustable rate mortgage, your payments will move higher as well, which takes away some of your purchasing power. 

How will higher rates affect your investment portfolio?

What about the effect that rising rates could have on your investment portfolio?
While a hike in interest rates could cause a temporary dip in your portfolio’s performance, it’s unlikely to have a permanent or far-reaching effect because your portfolio manager would have been making incremental adjustments already, in anticipation of the interest rate increase. 
Here are the key steps that portfolio managers at Cambridge Trust take to minimize the impact of higher interest rates.

Step 1: Confirm why you’re investing in fixed income securities in the first place.

Is your goal to stabilize returns, reduce risk, or create income? Bonds and other fixed income securities can do all of these things, but how your portfolio manager responds to a rising rate environment will depend on what you’re trying to achieve and the primary role that fixed income securities play in your portfolio. For example,
  • If the bonds in your portfolio are used to create steady income in retirement, it may be just fine to continue to hold them to maturity, earning interest along the way until your principal is returned. So, if you buy a 10-year bond today paying 2.9%, your return after 10 years will be 2.9%.
With a longer bond, of course, the “real” return could be much lower after inflation. However, a shorter term bond or note is less influenced by the effects of long-term inflation.
At the same time, there could be an “opportunity cost” to this holding strategy, which your portfolio manager will also consider. (See Step #4 below.)
  • If you own fixed income securities primarily to stabilize or balance more volatile equity/stock investments, your portfolio manager will take a close look at the mix of these investments to make sure they can still do this. He or she might scale back the amount of riskier high yield bonds you own, for instance, to further reduce portfolio risk and volatility.
  • If you own municipal (muni) bonds for income and tax efficiency, your portfolio manager will review how higher rates will affect them as well.

Step 2:  Look at the types of fixed income investments you own.

At Cambridge Trust, we prefer purchasing individual bonds and fixed income securities rather than mutual funds for the core of our portfolios[1] because this gives us more control and flexibility, particularly when it comes to managing those investments during a period of rising interest rates.
However, there are cases where we may use bond mutual funds to access unique corners of the market and supplement the core portfolio as needed. Read more about why we focus on individual bonds in our Bond FAQs.
The individual fixed income securities we consider for client portfolios—investment grade corporate bonds, municipal bonds, mortgage backed securities, US government securities, as well as US treasuries—all carry different risks based on their issuer and credit ratings. They also react differently to interest rate increases, which is why we manage them differently too.
  • If you own 20-year investment grade corporate bonds, for example, their longer maturity will make them more susceptible to interest rate increases/price decreases over time, so reducing the duration of those bonds is a reasonable strategy. (See #3 below.)
  • If your fixed income portfolio is more conservative and you already have a larger allocation to “safer” US government securities or Treasury Notes that will mature in a year or less, it’s less likely that we’ll make changes to these investments if interest rates rise.

Step 3:  Gradually shorten bond durations.

In a rising rate environment, it is hard to predict exactly how high or how quickly rates will increase. That’s why we believe the most effective move your portfolio manager can make to diminish the impact of rising interest rates is to gradually reduce the “duration” of your portfolio.
We can accomplish this in a number of ways, but it typically involves buying shorter term fixed income securities or selling longer maturities. Moving to shorter duration fixed income securities means that the money can be reinvested more quickly into higher yielding securities when interest rates are moving up.
For more on how we manage bond portfolios to respond to rising rates and changes in the yield curve, see our Bond FAQs.

Step 4: Consider the opportunity cost.

If your bonds were purchased to provide steady income and stability rather than for potential gains from buying and selling, it can be tempting to simply sit out a rate increases and hold the bonds to maturity when your principal will be repaid. But that’s not always the best strategy to maximize your income and portfolio returns.
That’s why we also do a cost/benefit analysis to look at the opportunity cost of selling versus holding the bonds in your portfolio in a rising rate environment. That is, if you were to sell a bond with a lower rate at a loss and replace it with a bond that pays higher interest, where is the point where the higher income you’ll receive recoups your loss? We might decide not to hold on to that bond, because selling it produces a much better result—and more income over time.
For portfolios that have significant gains on the stock side, there also may be an opportunity to “harvest” some losses on the bond side to help reduce/offset the portfolio’s overall tax liability.

Step 5: Run “what if” portfolio simulations.

As we look for ways to cushion your fixed income portfolio from the effect of rising interest rates, we will also use our proprietary software to run simulations that show how different portfolio configurations respond to different rate scenarios.
This allows us to explore how the new rates might affect the fixed income components of a client’s portfolio, and determine how to best position the securities before we make the actual changes. It also gives us the opportunity to be more proactive than reactive to changes in interest rates when we anticipate that they will rise—or fall. 
Clearly, there is no single answer to how to manage an investment portfolio during a period of rising interest rates. Each portfolio has its unique challenges. However, by focusing on the steps outlined above, your Cambridge Trust portfolio manager can create the optimal strategy for your individual needs.
This article is for informational purposes only and should not be construed as investment or legal advice

[1] As long as the accounts can meet minimums and have adequate size to reasonably diversify.