Fixed-Income Strategies for a Rising-Rate Environment
Rick Spencer, CFAFixed-Income Trader
Mar 13, 2017
Interest rates have begun to trend higher after bottoming in July 2016. After reaching a low of 1.36 percent last year, the 10-year Treasury yield recently hit 2.6 percent and currently rests at a 2.56-percent yield, as of March 8, 2017. Higher interest rates have benefited bond buyers with higher starting yields but will become a source of concern if rates continue to climb.
Inflationary pressure is beginning to show itself in the prices of commodities. Brent Crude oil is up more than 50 percent over the last 12 months, and industrial and agricultural commodities from copper and aluminum to cotton and sugar are also showing strong price increases over the last year.
These increases are beginning to creep into the consumer price index (CPI), as well. The CPI increased 0.6 percent in January on a seasonally adjusted basis and is now up 2.5 percent over the last 12 months.1
These inflationary pressures are spilling over into the fixed-income markets. The chart below shows the rising trend over the last 12 months.
The new higher-rate environment raises questions for investors, such as “Does my investment strategy still make sense?” For most investors, laddering bonds from three to seven years makes sense, as it allows increasing income over time as bonds mature, allowing the reinvestment of proceeds into new bonds with higher coupons. This maturity range affords excellent diversification potential because of the large number of issuers and industries represented.
The long-expected rise in rates has prompted other investors to look for a magic bullet that will protect them against higher rates. As you might expect, there is no one magic bullet, but there are types of bonds and CDs that can provide hedges against rising rates.
Step-Up Coupons Can Provide Some Protection against Future Rate Increases
A step-up CD or bond is a security with a coupon that increases ("steps up"), at predetermined dates, while the bond is outstanding. Step-up CDs are issued by major banks, typically in maturities of three to five years. These CDs are generally callable every three months. The starting coupon for the step-up typically is lower than fixed-coupon CDs of the same maturity, but as the coupon steps up, it will overtake that of the fixed-rate CD if it is not called.
Recent five-year offerings feature starting coupons of 1.35–1.4 percent, climbing to 3.1–3.15 percent over the life of the CD. Current fixed-rate CDs are being offered with 2.35–2.4-percent coupons for the same maturity.
Step-ups work best as complements to fixed-rate CDs. If you buy a five-year step-up CD, it might be outstanding for three months or six months before being called; in a rising-rate environment, it might stay outstanding until maturity. As the coupons rise, the potential for a call increases. The investor should be comfortable with monitoring the portfolio and occasionally shopping for new issues.
Step-up bonds are issued less frequently than CDs, so the best offerings are typically in the secondary market. Like the CDs, they are generally callable quarterly or semiannually. Starting coupons are typically 2.75–3.75 percent. Many of these issues currently trade below par, making near-term calls less likely. There is great diversity in the coupon steps, call schedules and maturity dates, and liquidity should be considered, as well. Small secondary offerings may trade at wider spreads and may be more difficult to sell.
Floating-Rate Bonds Will Pay Increasing Coupons If Underlying Rates Rise
Floating-rate securities make interest payments that float or adjust periodically based upon predetermined benchmarks. The London Interbank Offered Rate (LIBOR) and CPI are commonly used benchmarks. Financial firms issue most of the floaters currently outstanding. The offerings normally are subordinated to the firm’s fixed-rate debt.
“Floaters” generally pay interest quarterly, and the coupon rate typically resets with each payment. Some issues have different reset schedules, so it’s important to study all of the details before making a purchase. In the current environment, many of these bonds have coupons of 2–2.5 percent, while some of the longer maturities yield as much as 5 percent.2
Navigating the floating-rate bond market can be challenging — coupon and call schedules can be complex, and trading in the issues can be thin. For some investors, mutual funds or ETFs might be more appropriate to gain exposure to this segment of the market.
Survivor Option Bonds Allow Older Investors to Protect Capital While Getting Competitive Yields
A survivor option bond is a bond that allows heirs to redeem the bonds at par following the death of the bond owner. Many older investors limit their investing to short or intermediate maturities, as they don’t want their heirs to be stuck with losing positions in bonds. The survivor option feature effectively puts a floor under the bond’s value, within certain limitations. During a period of rising rates, it helps to provide the estate a substantial amount of capital appreciation that’s potentially greater than that of the market.3
Several sources estimate that survivor option bonds yield 10–15 basis points less than option-free bonds of the same quality. The bondholder would be giving up some potential income in order to have the ability for beneficiaries to put back the bonds at par.4
There are some requirements for the exercise of the survivor option. “First, the bondholder must have passed away. Second, the bonds must be put back to the issuer while the securities are still in the account of the deceased holder. Once the bonds have been transferred to another account, the put is no longer valid.” In addition to the above, there can be other limitations, including minimum holding periods, annual redemption limit for issuer, Individual annual limit and types of account registration.5
Current offerings for five-year high-quality investment-grade offerings yield 3 percent versus CDs at 2.3 percent. At the 10-year maturity point, 4-percent yields are available versus 2.8 percent for CDs. Many of the longer bonds trade at premiums. Investors should consider that the survivor option will likely only come into play over a longer timeframe for these bonds. If the owner passes away while the bond is at a premium, the survivor option does not provide any benefit.
For most investors, the straight bond ladder provides diversification, periodic income and flexibility to their portfolio strategies. For those with unique situations or who want to structure their portfolios for specific interest rate scenarios, they may want to explore some of the alternatives to conventional bonds. Having a conversation with your advisor can help you further understand these alternatives and whether or not they are suitable options for your fixed-income portfolios.
1 Economic News Release: Consumer Price Index Summary. Bureau of Labor Statistics, Feb. 15, 2017
2 “A Guide to Understanding Floating-Rate Securities.” Raymond James.
3 “Survivor’s Options Bonds.” Janney Corporate Credit, February 2016.
4 Thangavelu, Poonkulali. “What are death puts and how do they work?” Bankrate.com.
5 “Survivor’s Options Bonds.” Janney Corporate Credit, February 2016.
Investing in fixed-income securities involves special risks, including credit risk, which is the risk of potential loss due to the inability to meet contractual debt obligations, and interest rate risk, which is the risk that an investment’s value will change due to a change in the level of interest rates. There is an inverse relationship between bond prices and interest rates specific to fixedincome securities. As interest rates rise, bond prices fall, and conversely, as interest rates fall, bond prices rise.
Asset allocation/diversification of your overall investment portfolio does not assure a profit or protect against a loss in declining markets. Investing in a non-diversified fund that concentrates holdings into fewer securities or industries involves greater risk than investing in a more diversified fund.
All opinions expressed and data provided are subject to change without notice.
Some of these opinions may not be appropriate to every investor.
Index performance does not reflect the deduction of any investment-related fees and expenses. It is not possible to invest directly in an index.
Securities offered through 1st Global Capital Corp. Member FINRA, SIPC. Investment advisory services offered through 1st Global Advisors, Inc. 1st Global Capital Corp. is headquartered at 12750 Merit Dr., Ste. 1200 in Dallas, Texas 75251; 214-294-5000. Additional information about 1st Global is available via the Internet at www.1stGlobal.com.
Rick Spencer is a fixed-income trader for the Capital Markets Group at 1st Global. In this role, he partners with affiliated advisors to apply his fixed-income expertise to discover and create solutions that meet the clients’ needs.