Fixed Income Investing in Current Markets

Sean Boughal, AWEMBA 2014

Professor Mike Gallmeyer

Situation: Client is concerned with fixed income portion of her portfolio due to the current interest rate
environment and potential for rising rates. Below is a snapshot of her current portfolio weightings:

70% US and International Equities

30% Barclays Capital US Aggregate Bond Index ETF (LAG)

Client risk profile is that she is in her mid-40s, has a long investment horizon, but is somewhat risk
averse.
Mission: Client wants advice on what to do with her fixed income portion of her portfolio. Options
available include:
1. Moving out of Fixed Income
2. Maintain current bond ETF position
3. Reallocate into other fixed income strategies
Analysis of Options:
First step in analyzing the clients situation is to assess the pros and cons of the options available to her
keeping in mind her fears of the current interest rate environment and the potential for increasing rates.
1. Selling out of her fixed income portion of her portfolio is not a prudent option: One of her inputs
was to inquire if moving out of fixed income will be the best solution to her concerns.
Quantitatively we know this not to be the best option, historically fixed income is a great volatility
dampener of an equity portfolio. Since she owns 70% equity, increasing that to 100% would not sit
well for her risk profile. Below is a graphical example using historical data to show how fixed income
in her portfolio reduces portfolio volatility:

Fixed Income Investing in Current Markets

Sean Boughal, AWEMBA 2014

Professor Mike Gallmeyer

2. Before assessing her current fixed income allocation we need to first take a look at the factors that
affect the price of a bond and to see how increasing rates will play a role in effecting her allocation.
The three critical factors are credit quality of the issuer, the liquidity of the asset, and duration.
a. Credit quality: A measure of default risk of an issuer. The higher the credit quality of an
issuer the lower the default risk and the lower the expected yield, and vice versa. Increasing
rates does not directly affect credit quality.
b. Liquidity: Ability to convert bond to cash without paying large dealer spread. In this case,
the more liquid the bond the lower the principal risk and the lower the expected liquidity
yield an issuer can get in the market, and vice versa. Increasing rates does not directly
affect liquidity.
c. Duration: How long, in years, it takes for the price of a bond to be repaid by its cash flows,
and the primary measure of a bonds sensitivity to interest rate swings. The longer a bonds
duration the more sensitive its price will be to interest rate movements.
Now that we know the critical factors that affect the price of a bond we can assess these dynamics
as they pertain to the clients allocation in the LAG ETF. LAG is a passively managed ETF that seeks
to replicate the underlying Index. The underlying Index is an average maturity (~5 years), market
capitization weighted index that includes all US bond types of investment grade quality (i.e.
Municipal, Treasury, Corporate, MBS, etc.). For an increasing interest rate environment, LAG is not
the ideal asset allocation due to the following reasons:
a. Yield determined solely by its duration: Since the index is invested in investment quality
bonds that are weighted by market cap, the major contributor to its yield is duration as
credit quality and liquidity factors have little effect. This makes the index very sensitive to
an increasing interest rate environment. In fact, almost 50% of the index is weighted in US
Govt bonds.
b. ETF weighted heavily on most liquid bonds: Due to liquidity concerns for the managers of
the ETF, LAG is even more heavily weighted to the most liquid bonds in the underlying
index, which actually makes the ETF even more sensitive to rising rates than the index itself.
c. Supply and demand concerns of ETFs: Since ETFs trade like equity, the ETF is basically a
slave to investor sentiment that can add to the volatility to the clients portfolio.
3. After reviewing the key factors that affect a bonds price and determining that the LAG ETF is not
the best fixed income allocation, I will review a few strategies that can mitigate the effect of interest
rate risk. Since we know that a bonds price sensitivity can be written as:
Bond Price Sensitivity = Credit Quality factor + Liquidity factor+ Duration factor
The only way to dampen the effect of duration on a bonds price is to increase the effect of credit
quality and liquidity, and/or decreasing its duration. Following are strategies that can be employed
to mitigate interest rate risk to a fixed income portfolio:
a. Actively manage bond portfolio duration: Managing duration in a bond portfolio is a rather
simple strategy that relies on overweighting shorter maturity fixed income assets to counter
a rising interest rate environment.
i.
Short duration strategies: By diversifying a fixed income portfolio across sectors in
products with durations of 2 years and less. The only trouble with this approach is
its success also depends on the current and future yield curve. For instance, while it

Fixed Income Investing in Current Markets

Sean Boughal, AWEMBA 2014

Professor Mike Gallmeyer

will protect the investor from increases in interest rates, in the current
environment, short duration yields are close to 0% and dont offer much income
potential. Also, unlike FDIC insured deposits, these instruments are not principal
guaranteed and have a very slight default risk that may not be compensated by the
low yields offered.
ii.
Diversifying duration strategies: By breaking up a fixed income portfolio into
differing durations spreads out an investors cash flows and diversifies the interest
rate risk. For instance, creating a diversified bond ladder allows the investor to
dollar cost average into any interest rate increases. The downside is the fact that
this strategy will always be behind the interest rate curve, though may be mitigated
over time as interest rates fluctuate down as well.
b. Diversify into differing sources of yield: These types of strategies effectively overweight the
credit risk and liquidity factors in a bonds price, thus reducing the effect of duration and
interest rate risk.
i.
Credit quality strategies: The obvious choice here is diversifying a portfolio into
high yield fixed income instruments that demand a higher yield due to the lower
credit quality of the issuer. The other potential benefit of investing in high yield
corporate bonds is that, if done effectively, a rising interest rate environment
implies improving economic conditions and improving credit quality of the issuer,
decreasing the spreads and offsetting the interest rate risk further. The risk with
this strategy is default and principal risk.
ii.
Liquidity strategies: Similar to credit quality strategies, and especially if held to
maturity, an investor could seek out less liquid fixed income instruments that
rewards the illiquidity factor with a higher yield.
iii.
Emerging Market strategies: Another overlooked fixed income strategy would be to
diversify into Emerging Markets. Typically Emerging Markets are less correlated to
US markets and offer a credit quality and liquidity premium. The potential risks are
the same here, but also have the added risk/reward of currency fluctuations.
c. Diversify into non-traditional / combination strategies: Actively managed fixed income
funds that employ a combination of techniques including hedging and long/short strategies
also offer opportunities in a rising interest rate environment. A high interest rate
environment usually correlates to higher fixed income volatilities for active managers to
potentially exploit.
Recommendation: After reviewing the clients risk profile and with the knowledge gained from class
and readings, I would recommend the client reallocate into a diversified fixed income portfolio that
employs a combination of strategies discussed in topic 3 above. Due to the potential complexities of
dealing in high yield and low liquidity instruments, I recommend the client seek an actively managed
fixed income portfolio. Specifically, the recommended allocation weightings would look something like
the following (+/- % after a final meeting with a fixed income expert and review with the client):

Fixed Income Investing in Current Markets

Sean Boughal, AWEMBA 2014

Professor Mike Gallmeyer

Sample fixed income reallocation to offset rising interest rate environment (total fixed income portfolio
= 30%):

~15% Managed Duration Strategies: Set up a diversified 1-2-3-5 year bond ladder.
~5% Combination credit quality/liquidity strategies: actively managed high yield bond fund.
~5% Emerging Market fixed income strategy: actively managed fund.
~5% fixed income hedge fund: highly rated manager that specializes in high rate environment.