January 03, 2011 by SEI Investment Management Unit

Since the financial crisis of 2008, there has been a significant increase in the volatility of interest rates. This matters to fixed-income investors because changes in interest rates directly impact the market value of bonds and bond portfolios. For example, if you own a bond worth $1,000, on which the borrower (issuer) will pay you $40 of interest per year until maturity, then the nominal yield on the bond is 4%. If interest rates (the yield demanded in the market on similar bonds) rise to 5%, then the market price of your bond – that is, what you would receive if you sold it instead of holding until maturity — will fall until the fixed $40 annual coupon payment represents roughly 5% of the new market price. In this example, $40 / 5% = $800, so the $1,000 4% coupon bond would fall 20% in price to $800. If you hold the bond to maturity, you will still receive its full face value, as long as the issuer doesn’t default. This is a hypothetical example, and it’s important to understand that there are many factors besides interest rates (such as time to maturity) that affect the price of individual bonds.

While we believe a sustained rise in interest rates remains a low probability in the near term (as rates remain near historic lows despite their high volatility), bond investors must still be aware of the risks that rising interest rates pose. Professional money managers and individual investors tend to look at these risks differently. For professionals, the prospect of rising interest rates may influence how they construct a portfolio, but they still must work within the constraints of their investment strategy. A bond fund manager, for example, is not going to buy stocks regardless of the direction interest rates move. For individual investors, the situation is more fluid. As such, there are several possibilities for managing the risks and exploiting the opportunities associated with rising interest rates.

The View from Wall Street

The ultimate goal for a professional money manager is to outperform an assigned benchmark. As a result, investment performance is measured in relative terms. For example, if a manager’s benchmark were to fall by 10%, while the manager’s portfolio fell by 9%, then the portfolio outperformed its benchmark by 1%, or 100 basis points. Relative performance is the applicable measure for investment managers regardless of whether markets are rising or falling. With stubbornly high levels of unemployment, slow economic growth, the questionable effectiveness of government policies, and low inflation, most professional investors do not expect meaningfully higher interest rates anytime soon.

Even in the absence of rising rates, investment managers are still faced with the challenge of performing well on a yield basis relative to their benchmarks. In recent years, attractive yields have been hard to come by in U.S. Treasuries (the most conservative, least volatile offerings). Yields on ten-year Treasuries were below 3% until recently, while thirty-year Treasuries have yielded below 5% since 2007. High-quality corporate bonds are similarly unattractive. One large corporate issuer recently issued three-year notes with a paltry coupon rate of 0.875%, a mere 25 basis points (0.25%) over Treasuries of comparable maturity. As a result, portfolio managers searching for yield must look to other types of debt securities, such as non-agency mortgage-backed securities (which hang under a cloud of mortgage defaults and foreclosures) and high-yield corporate bonds (often referred to as “junk bonds” due to their low credit ratings and higher risk of default).

The View from Main Street

In a perfect world, bond investors would always be able to purchase high-quality bonds with attractive yields. Since that scenario has been largely nonexistent in recent years, it’s reasonable to assume that the typical individual bond portfolio holds many low-yielding, richly priced securities. In an environment of historically low rates, individual investors may feel as though yields have nowhere to go but up, which would cause the values of their bond portfolios to decline.

A common measure of a bond portfolio’s sensitivity to interest rates is duration, which provides an estimate of how much a portfolio’s value will change given a 1% change in interest rates. Portfolio duration is primarily a function of the average maturity of its individual securities. For example, if a fixed-income portfolio has a duration of five years, it means that the value of the portfolio is expected to decline by approximately 5% if interest rates rise by 1%, and rise by approximately 5% if interest rates decline by 1%. As of December 31, 2009, the duration of the Barclays Capital U.S. Aggregate Bond Index, which is commonly used to represent the investment-grade U.S. bond market, was 4.57 years. It is currently estimated to be just over 5 years. Thus, individual investors who hold a fixed-income portfolio that behaves similarly to the overall bond market face a potential loss of roughly 5% for every 1% rise in interest rates.

Because professional portfolio managers are focused on relative performance, they may not panic over the possibility of negative returns in fixed-income markets. However, to individuals who are focused on investment performance in absolute rather than relative terms, the prospect of a 5% or greater loss on the market value of their fixed-income holdings can be disconcerting, to say the least.

What Should An Investor Do?

It’s understandable that an investor would consider lightening up on a security or an asset class that he or she believes might lose value in the near term. However, it is also important to consider that the behavior of most fixed-income securities is very different from that of stocks. Thus, what may seem like an obvious move—selling bonds because they could lose value—might do a portfolio more harm than good. Most bonds provide an ongoing stream of cash flows, and their price behavior tends to lower overall portfolio volatility when combined with other types of assets (notably stocks). Bonds also promise a contractually specified (though not always riskless) series of cash flows, including return of principal, while cash flows to stockholders are entirely speculative. Bondholders also have stronger legal rights than common stockholders, which is especially important when an issuer defaults or files for bankruptcy.

When evaluating proper portfolio positioning, the first question you should ask is: Why you are buying bonds? If you are buying bonds with cash flows that will allow you to meet specific future liabilities, such as funding a college education or entering retirement, then future interest rate movements are of secondary importance. If your primary objective is to manage overall portfolio volatility over the long term, then it makes sense to maintain your bond allocation and periodically rebalance your holdings (it should also be noted that the economic conditions that would be consistent with rising interest rates would probably help to generate positive returns from the stock portion of a well-designed portfolio). If your primary objective is current income, then, generally speaking, rising yields can be seen as a positive development, as the periodic cash flows arising from coupon payments, maturing bonds and even stock dividends can be reinvested at those higher interest rates.

However, for investors who are primarily concerned with generating absolute returns, this may be a good time to consider changing your asset allocation. Cutting back on fixed-income exposure in favor of equities may be a reasonable course of action that could help you move closer to your goals. Fortunately, there are many different approaches available to investors who want to make a tactical shift in their long-term investment strategies. For example, there are several choices available in the separately managed account (SMA) space. Treasury Inflation-Protected Securities (TIPS), though they normally provide a lower initial yield than their plain-vanilla counterparts, can help an investor’s coupon income keep pace with inflation. Laddered bond portfolios, in which individual bonds of various duration are held to maturity and cashed in at full value, can help to protect against losses (bonds in the ladder that are closer to maturity help to protect against rising interest rates, as they can be reinvested in the short term, while longer-dated bonds in the ladder help to protect against falling interest rates). Floating-rate notes periodically adjust the interest rate paid to investors, based on a specified reference rate; if the reference rate rises, the yield on the note (and thus the coupon payment) will adjust upward, preventing a loss of principal value.

Of course, investing decisions always involve tradeoffs, and each of the options mentioned above involve certain risks. Consulting with a professional Financial Advisor will help you determine the appropriate course of action based on your personal financial needs.

SEI’s Portfolios: High Yield and Emerging Debt May Provide a Cushion

Professional money managers can make numerous adjustments in their bond portfolios to help mitigate the negative impact of rising rates. For example, in a low-interest-rate environment, SEI is willing to take on more credit risk via investments in high-yield bonds, the debt of emerging-market governments, and other higher-yielding sectors of the credit markets. While these securities are riskier than U.S. Treasury and investment-grade corporate debt, they pay higher coupons that provide more of a cushion against rising interest rates. At SEI, we have positioned our portfolios toward high-yield bonds and mortgage-backed securities (MBS) at the shorter end of the maturity spectrum. This shift demonstrated its value during the recent Treasury market decline, as the Barclays Capital U.S. Aggregate Index was down 2.29% and similar-duration Treasury securities were down 2.84%, while SEI’s SIMT Core Fixed Income Fund was down 1.57%.

SEI’s Longer-Term Position

Each of SEI’s Funds has a specific investment strategy that it will continue to employ. For example, SEI’s SIMT Core Fixed Income Fund “will invest primarily in investment- and non-investment-grade U.S. and foreign corporate and government fixed-income securities, including emerging-market securities, asset-backed securities and mortgage-backed securities.” When interest rates rise and stocks become more attractive than bonds, these Funds won’t be buying stocks; they will continue to invest in fixed-income securities in accordance with their mandates. As we noted earlier, for professionals, the prospect of rising interest rates is largely a non-issue. While we know that rising rates will create headwinds for fixed-income funds, we will navigate the marketplace while remaining true to our Fund’s stated investment strategy.

Among individual investors, the need to manage interest-rate risk, as well as the possibilities for doing so, will vary significantly. The best advice, as always, is to consult your professional Financial Advisor, who can help you determine the best course of action for your personal circumstances.

The performance data shown is past performance. Past performance is no guarantee of future results. The investment returns and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost and current performance may be lower or higher than the performance quoted. For performance data current to the most recent month end, please call 1-800-DIAL-SEI.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds.

For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement. SIMC is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co. (SIDCo.) SIMC and SIDCo are wholly owned subsidiaries of SEI Investments Company.

To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses, which can be obtained by calling 1-800-DIAL-SEI. Read them carefully before investing.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. Narrowly focused investments and smaller companies typically exhibit higher volatility. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.

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