A practical approach to rising rates
December 16, 2015
Investors have been anticipating an eventual upward swing in interest rates for months, if not years, and who can blame them? Changes in interest rates in either direction can affect the value of an investment portfolio, sometimes steeply and without much warning. Often, clarity about the direction of rates is hard to come by. But today’s circumstances are in many ways straightforward: The Federal Reserve is poised to keep rates inching up, and it has made its intentions known.
The Fed’s rate hikes: Issues for fixed income investors
When it comes to managing interest rate fluctuations, investors should keep in mind that interest rates are seldom extraordinarily volatile. It’s reasonable to expect this to be the case this time around, as the Fed seems most likely to pursue a gradual, tempered series of small rate increases. For example, during the tightening cycle of 2004-2006, the federal funds target rate was raised by increments of 25 basis points over a string of 17 successive policy meetings that spanned a period of two years (the Fed’s policy meetings occur roughly every six weeks). Although Fed officials will clearly be guided by U.S. economic data in 2016, there’s a strong chance they will move much more slowly and carefully than they did during the prior tightening cycle. By not raising at every meeting, they could create an environment that gives markets an opportunity to digest the fact that rates are finally coming off the near-zero level they have been held at for seven years. By implication, this means that we generally don’t expect to see extraordinary fluctuations in asset prices due strictly to tighter monetary policy.
We also note that prior periods of rising rates have had reasonably gentle effects on bond-market performance over the long term. Consider that broad markets, as measured by the Barclays U.S. Aggregate Index, have experienced only three annual declines since the index was launched 40 years ago (see chart).
U.S. bond markets: Evidence of long-term resilience
*The return for 2015 is year-to-date through Nov. 30, 2015.
Chart is for illustrative purposes only.
Strategies that fixed income investors might consider during periods of rising interest rates
In general, we believe that two elemental, time-tested strategies can help minimize the risks associated with changes in interest rates: (1) Build a fixed income allocation that includes a diversified collection of fixed income assets, and (2) think carefully about your risk tolerance and income needs when selecting your fixed income investments.
Specific tactics that may be appropriate in a rising-rate environment include the following.
- A shift toward investment grade corporate bond funds — In times of economic strength, the outlook may be brighter for high-quality corporate debt securities than for U.S. Treasury bonds. Corporate bond prices, which are linked in part to the strength of corporate earnings, may hold up better than Treasurys in a rising interest rate environment.
- An allocation to floating-rate debt — Floating-rate investments may help reduce the interest rate sensitivity of an investment portfolio. Because the coupon payment on a floating-rate security is reset periodically, the security’s value is less sensitive to changes in market interest rates (compared to traditional fixed-rate bonds). What makes floating-rate securities unique is their response to prevailing market rates: while prices of traditional bonds fluctuate in response to changes in interest rates, prices of floating-rate securities tend to remain relatively stable. Furthermore, the income component of floating-rate securities generally increases during periods of rising interest rates. Talk to your financial advisor about how floating-rate fixed income investments may fit your investment plan.
- Holding more than one fund — Another way to spread risk across the bond markets is to hold several mutual funds that focus on different sectors. Such a portfolio might include funds that specialize in bonds issued by a range of different entities, such as:
- agencies of the U.S. government
- U.S. municipalities
- foreign governments
- foreign corporations
While no investment mix can provide complete immunization against interest rate fluctuations, investors who focus on diversification by spreading out investments across different asset classes have a good chance of staying on track in meeting their investment objectives. Your financial advisor can help you identify those opportunities that align with your tolerance for risk. Make your primary objectives clear to your advisor, so that your plan can be tailored to your distinct needs.
The views expressed represent the Manager's assessment of the market environment as of December 2015 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
The Bloomberg Barclays US Aggregate Index is a broad composite that tracks the investment grade domestic bond market.
Diversification may not protect against market risk.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.