Considering the current interest rate environment, many investors are either starting or expanding their fixed income position in their respective portfolios.
The high interest rate environment creates a unique opportunity where bond investments are becoming increasingly attractive due to the significantly higher coupons. Furthermore, given your time horizon, if you can lock in a higher duration for your investments, then you can potentially reap the benefit of your current investment long into the future. In addition, as many economists are indicating, when the market conditions start to normalize and we begin seeing a decline in interest rates, the current investment may also be in the money in terms of their market value, also known as premium.
In this article, we will take a closer look at how rebalancing or position your portfolio in the current market can help to capitalize on higher potential yields.
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A Higher Duration Strategy
A relatively higher duration strategy can be a good option for a fixed income portfolio in certain circumstances. Duration is a measure of the sensitivity of a fixed income security or portfolio to changes in interest rates. Typically, a higher duration indicates greater sensitivity to interest rate changes, while a lower duration indicates less sensitivity. Here are some situations when a higher duration strategy may be appropriate:
1. Dynamic Interest Rate Environment
Antecedently, when interest rates are low or are expected to decline, a higher duration strategy can help maximize returns, given a normal yield curve; hence, a higher duration yields higher returns. As interest rates fall, the prices of fixed income securities rise, and longer duration securities tend to rise more than shorter duration securities.
However, the same concept applies as the Fed increases interest rates in the wake of higher inflation, which happens to be the case in the current economic times. As aforementioned, in a high interest rate environment, investors can chase the higher coupons and lock in the relatively high duration to capitalize on those coupon payments for a long period of time. In this case, even when interest rates come down, you will be able to capitalize on the premiums on your debt holding; In addition, the higher the coupon and duration, the larger the premium, which can be a win-win scenario. However, investors must also be aware of a situation where the interest rate continues to go up, which will likely generate unrealized capital losses.
2. Longer Investment Horizon
If an investor has a longer investment horizon, a higher duration strategy may be appropriate. Over a longer time period, interest rate changes can be weathered knowing that there isn’t a need for cash in the near future. As mentioned earlier, the negative impacts of interest rate swings should theoretically correct over a longer period of time, given the investor understands the market volatility and is OK with interest payments and able to wait until the security matures for the principal payment.
3. Diversification
A higher duration strategy can provide diversification benefits when combined with lower duration securities in a portfolio. Higher duration securities tend to have a lower correlation with lower duration securities, which can help reduce overall portfolio risk. This can also help maximize the return while minimizing the risk posed by similar maturities.
4. Liability Matching
If an investor has long-term liabilities, such as pension or insurance obligations, a higher duration strategy may be appropriate. Longer duration securities can help match the duration of the liabilities, which can help reduce the risk of shortfalls or unexpected cash flow needs. Many investors tend to arrange their fixed income portfolios in a tier structure, which helps with the expenditure needs but also helps navigate the portfolio through market changes.
While the outlook for municipal debt is generally positive, there are several potential risks that investors should be aware of. One such risk is the possibility of default. While municipal bonds have historically had a low default rate, there have been several high-profile defaults in recent years, including the bankruptcy of the City of Detroit in 2013. Investors should carefully evaluate the creditworthiness of the issuer before investing in municipal debt.
Another potential risk is the impact of rising interest rates, which has been impacting many fixed income portfolios over the past year. As interest rates rise, the yield on municipal bonds will also rise, which could make them more attractive to investors. However, rising interest rates could also cause the value of existing municipal bonds to decline, which could lead to losses for investors who need to sell their bonds before they mature.
The Bottom Line
It’s important to note that a higher duration strategy also carries risks. In addition to interest rate risk, it can also be exposed to credit risk and liquidity risk. Therefore, it’s important for investors to carefully consider their risk tolerance, investment objectives, and time horizon when deciding whether to pursue a higher duration strategy for their fixed income portfolio.
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