As the global economic expansion enters its tenth year, central banks are increasingly looking to normalise monetary policy. After years of record low interest rates, many investors are now considering how to position their portfolios for a rising rate cycle.
At PIMCO, we often get asked for our views on this, and in particular, whether to lower exposure to core bonds given that bond prices fall as interest rates rise.
Over the long-term, we don’t recommend this. Core bonds play a crucial role in portfolios, providing diversification and capital preservation. As yield curves are typically upward sloping, investors also benefit from a “term premium”, which is the excess yield from holding longer term bonds.
However, over shorter time periods, many investors can be uncomfortable with the level of interest rate risk (duration) in their portfolios. In these instances, here are three strategies we recommend:
- Systematically lower duration: Low duration bond strategies have lower sensitivity to interest rates and will typically mitigate capital losses associated with interest rate spikes. However investors should bear in mind that these strategies may have lower yields than core bonds, which could reduce long-term return potential.
- Tilt portfolios to credit: Adding credit can help diversify the sources of return in a portfolio. It may also increase the yield, providing a cushion against the price impact of interest rate rises. The credit allocation can take various forms, such as investment grade, high yield or emerging markets, depending on required risk and return targets.
- Increase flexibility: Using more outcome-oriented strategies, such as those with a specific income or absolute return target, can be another solution for rising rates. These strategies typically have broader guidelines to allow the manager to navigate a wider range of market environments. It should however be noted that these strategies rely on manager skill to navigate the cycle and that interest rate exposures can vary over time.
There are pros and cons to all of these strategies and typically we find that clients who are concerned about interest rate risk wish to use a combination of them to position their portfolios for rising rates.
Explore model portfolios designed for rising interest rates: