The Federal Reserve is on a mission to tame inflation. In the first quarter it raised the fed funds rate for the first time in more than three years, and then it followed up in May and June with additional increases. We might as well get used to this because a slew of additional rate hikes seems like a virtual certainty.

Given this backdrop, investors might want to carefully revisit their fixed income allocation and, if necessary, consider corrective action.

Beware unintended consequences

Rising rates can wreak havoc on a bond fund because of the inherent negative correlation between interest rates and prices. Consider what happens when rates rise. For bonds previously issued when rates were lower, investors demand a higher yield to reflect the new higher-rate environment, and that manifests in lower prices.

For years—decades really when looking at the longer-term trend—interest rate risk has not bothered investors all that much because lower rates showed up as higher prices and higher portfolio values. That perception has changed recently, and given the Fed’s communication to the market, we might be stuck in this new rising-rate paradigm (even though we acknowledge that predicting interest rates is notoriously difficult and that investing for income should be the primary driver).

Consider how the Bloomberg US Aggregate Bond Index (the “Agg”) has evolved over time. The Agg is a benchmark that’s widely used to track the U.S. investment-grade bond market, and this index offers an impressive cross-section of securities and includes Treasuries, government agency bonds, mortgage-backed bonds, corporate bonds, and even a dollop of foreign bonds traded in the U.S. Many investors buy funds that track the Agg as a means to build a diversified bond portfolio. What they may not realize, however, is that the interest rate risk associated with the Agg has increased materially over time.

As the graph illustrates, the duration* of the Agg has increased substantially over the past decade. Thus, any investor that uses a fund that tracks the Agg for fixed income exposure has inadvertently increased his or her exposure to interest rate risk by almost 50%, as duration has gone from roughly 4.6 in the early 2000s to 6.8 more recently. So while many investors have gravitated to a passive approach based on the Agg for their bond allocation, being passive and “doing nothing” over the past decade may have resulted in taking on much more risk than intended (or appropriate) given the Fed’s stated outlook for rates. 

Course correction?

This is not the first time we’ve pointed out some limitations of a passive approach to fixed income. A better strategy might be for investors (or advisors on behalf of their clients) to first ascertain the appropriate level of interest rate risk and then construct portfolios accordingly. Why would you leave this vital decision to the vagaries of a passive index that changes over time?

One approach to better dial-in the right duration/income balance is to consider the possible merits of adding in shorter maturity corporate credits. The duration of short-term credits—illustrated by the Bloomberg 1-3 Year Credit Total Return Index—has been fairly stable over the past two decades, hovering between 1.75 to 2.19, and as of year-end 2021 duration was 1.88. Short maturity credits may prove to be a valuable tool in  managing duration risk within a broader portfolio. 

For example, a 25% allocation to short-term credits with a low duration (under 2.0) and a 75% allocation to an intermediate-term bond fund that carries slightly more interest rate risk (but still under 6.0) could net a more balanced portfolio with a total duration of near 5.0. This just might be—depending on an individual’s circumstances—a more appropriate trade-off between interest rate sensitivity and income potential. A similar approach could also be had by pairing an ultra-short bond fund, which typically carries an even lower duration, and a slightly more aggressive or broad-based income fund, which tends to carry slightly higher credit risk as a means to capture higher yield. 

In both the above scenarios, an investor could lower duration risk while increasing yield potential. Admittedly this might be achieved through higher credit exposure, but an active portfolio manager may be able to manage such credit risk through security selection and fundamental analysis. 

Ultimately, there’s no hiding from the notion that our new monetary policy will challenge bond investors. And while “doing nothing” can be good advice when it comes to reacting to volatility, it might be appropriate to “do something” about an existing fixed income portfolio that was once better situated for when rates were trending lower. We don’t advocate investing solely on macroeconomic or interest rate forecasts, but we do think it’s a good idea to ensure that duration exposure is not only intended, but that it also matches interest rate risk tolerance.