Fixed Income – What to Do When Interest Rates Rise

You'll need to rejigger your fixed income portfolio when interest rates rise.

   

Investors have enjoyed record-low interest rates for some time. (Of course, you’re only “enjoying” those low interest rates if you’re borrowing money.)

6SmallCapsWith10yield Fixed Income   What to Do When Interest Rates RiseHowever, if you’re trying to generate fixed income, this period has probably unsettled you. You’ve probably abandoned your traditional bond portfolio by now and had to move further out on the risk curve to seek out the fixed income you previously enjoyed.

Of course, now that you’ve done that … what do you do about fixed income when interest rates begin to improve again? (And interest rates will rise again — it’s just a question of when.)

The fear for most fixed-income investors is that when interest rates rise, all the people who put money into newer types of fixed income will abandon those choices and return to bonds, thereby sending those investments into a tailspin.

That might happen, but it’s no lock. Let’s look at a few scenarios to see what might happen to various yield-bearing assets:

Preferred Stock

I love preferred stock for fixed income because these stock-bond hybrids tend to move in tight ranges and pay yields of 7% or more. When the price of a preferred stock moves below par — which is its issuing price, usually $25 per share — the yield consequently rises.

The 30-year Treasury yield has bounced around from 2.5% or so to 4.75% over the past five years. When it went from 2.82% to 3.92% last year, preferred stocks in general fell about 10%. Now it’s back down to 3.1%. So it’s fair to guess that preferred stocks appear to be somewhat correlated to the 30-year Treasury.

Preferred stocks that yield above 7.5% — and a lot of them do, such as Ashford Hospitality Trust (AHT) Series D and E, which are 8.45% and 9% issuances, respectively — will be affected less by a move in the long bond. Indeed, many of these already trade above par anyway.

I would advise setting a 10%-12% stop-loss on preferred stock issuances so you move out of this fixed income sector if rates significantly rise.

Exchange-Traded Debt

I wouldn’t think exchange-traded debt would be especially sensitive to rate movements because it is higher in the capital stack than preferred stock, is more secure and trades more like bonds. Yet during the same period last year when the long bond took over, fixed-income ETDs were all over the place, depending on several factors.

General Electric Capital 4.875% Notes lost 20% of its value, likely because of its low yield. Weingarten Realty 8.1% Notes fell 13% despite its higher yield. Yet Goldman Sachs 6.125% Notes only fell 5.5%.

ETDs don’t seem to go down as consistently as preferred shares, but because they’re still volatile, safety is the name of the game here, too. I’d set a 12% stop here as well.

Other Fixed Income

Real Estate Investment Trusts (REITs): The Vanguard REIT ETF (VNQ) fell 15% during this same period. That’s a big hit for a sector that is so solid, and that’s also likely due to the fact that most yields there are under 5%.  If rates rise, there could be a rush for the exits. Why hold a REIT with all its associated risk, and the harsh memory of real estate collapsing in recent years, when you can purchase government bonds at the same or slightly lower yields? That might force REITs to offer better yields, which in turn might constrain their cash.

Master Limited Partnerships (MLPs): The Alerian MLP ETF (AMLP), however, barely budged at all. This appears to be the safe haven as far as interest rates are concerned. In this case, MLPs have the advantage of working in a sector where there is always demand.  The world will always need oil and natural gas, and therefore MLPs will always have a place.  Because this is a specialized type of business, fees charged tend to be high, and they tend to drive profits and, therefore, dividends.  MLPs are also more likely to provide capital gains, making them more attractive even to fixed income investors.

Closed-End Funds (CEFs): Also exempt appear to be closed-end funds. The YieldShares High Income ETF (YYY) remained stable during the period of rising rates. I think YYY specifically is a safe play because it is basically a fund of funds, investing in other CEFs that offer yields from a variety of sources. YYY’s yield is up around 9% right now; and even if some of its holdings take a hit, the ETF can always move assets into higher-yielding plays to compete with rising rates.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of Asymmetrical Media Strategies, a crisis PR firm, and PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com and follow his tweets at @ichabodscranium.


Article printed from InvestorPlace Media, http://investorplace.com/2014/09/fixed-income-interest-rates/.

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