Managing Interest Rate Risk

Post on: 26 Июнь, 2015 No Comment

Rising interest rates are a concern on everyones mind as they look at their portfolio over the next five years. Not surprisingly, a common question we receive is how do we protect a portfolio against rising rates?

There are multiple techniques portfolio managers can use to reduce interest rate risk. However, its important to first differentiate our Vertex Enhanced Income Fund as a credit fund. By that we mean that our primary concern as managers is assessing the credit-worthiness of a company in our investment process. Our views on interest rates do not dictate our investment decision. Investment decisions based on interest rates can lead managers to stretch maturities as they seek higher returns from the tail-end of the yield curve. In doing this, however, the interest rate risk increases. Which brings us to the first way a manager can reduce a portfolios interest-rate risk: shortening its duration.

Duration can be defined as the average time (in years) for the price of a bond to be repaid by cash flows. A bond that has a larger coupon will have shorter duration because the owner receives cash at a quicker rate. Shorter maturity bonds will also have a shorter duration to longer maturity bonds with a comparable coupon. The shorter the duration of the bond, the less sensitive its price is to changes in interest rates. So, if increasing rates are a concern, shortening ones portfolio duration can be achieved by purchasing high coupon, short maturity bonds. Both, the Vertex Enhanced Income Fund and the Vertex Fund currently invest in these types of bonds.

Another technique that can be utilized is strategy rotation. For example in the Vertex Enhanced Income Fund, we can increase our exposure to equities up to a maximum of 25% and add convertible bonds and preferred shares which are more correlated to equities than interest rates.

Investment catalysts can also help to reduce a bonds sensitivity to interest rates. Companies will often right-size their capital structure by eliminating or reducing expensive debt. For example, the Vertex Enhanced Income Fund and the Vertex Fund owned bonds issued by Burlington Coat Factory, which just recently completed an IPO. The bond indentures allowed for the purchase of up to 35% of one of their bond issues at a premium to par in the event of an IPO. For the company this helps to reduce their liabilities by swapping equity for debt which reduces their interest expense. We owned the bonds based on high cash-flow metrics, attractive yield with acceptable risk and the anticipation of a catalyst. Most private equity deals have a 5-7 year horizon, which means that the company will be looking for an exit, often via IPO. Bonds benefit from better credit metrics and are less sensitive to interest rates while the market speculates this as a possibility.

Lastly, we have yield-to-call bonds. Some bonds with a high coupon and short call window are candidates for refinancing and will behave more like a very short duration bond. For example, in the Vertex Enhanced Income Fund we owned bonds by Warner Music Group (WMG) that had a 4% yield to its 12-month call date. This means the company cant officially call the bonds (redeemed by the issuer prior to maturity) for 12 months. However, with an 11.5% coupon on the bond burning their cash, the bond was a candidate for early repurchase. We like the cash flow metrics and credit quality of WMG. If the company is worried about interest rates increasing, they may decide to refinance early in order to lock in the lower interest rate on a refinancing. This provides the company better cash flow characteristics over the next 5-7 years (depending on the term of the new issue). If WMG goes ahead with refinancing and issues new bonds, they will have to use the proceeds to buy back their outstanding debt. However, since the bonds are not callable for 12 months, the company will have to pay a premium to bondholders (called make whole + 50 bps for the technically inclined). This would equate to a large premium and because of this we view the investment as a cheap call-option on increasing rates.

So there you go. Those are a few examples of how we mitigate interest rate risk in an income fund. Lifes short (and so is our duration); let us worry about interest rates for you.

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