investment portfolios. In particular, meeting income objectives is a common challenge in this kind of environment.
There’s no one-size-fits all solution to this problem. However, we speak to many of our clients about using a multi-asset class approach. This simply means using multiple asset classes – equities, fixed income, and hybrid investments like preferred stock – to meet portfolio objectives. Each asset class is a “player” and, when combined, they form a “team.” Each player has its own set of special strengths, but no one player can deliver the results of the combined team.
So what kind of team should investors consider assembling in a rising rate environment? Well, if you fear inflation, your first-round draft pick might be Treasury Inflation Protected Securities (TIPS). My colleague Daniel Morillo covered this exposure in a recent blog post, so I won’t go into detail here.
But if inflation is less of a concern, what are some other players an investor might consider? Our group has been looking at a team that consists of high yield bonds (potential solution: iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG)), large cap equities (potential solution: iShares S&P Global 100 Index Fund (NYSEARCA:IOO)), and floating rate notes (potential solution: iShares Floating Rate Note Fund (NYSEARCA:FLOT)). And here’s why:
We did some analysis on the return impact of rising rates and increasing inflation expectations on these and other exposures, as measured by the sensitivity to changes in these factors. As expected, the return impact on 20+ year Treasuries was strongly negative, but was mildly positive for high yield bonds and more strongly positive for large cap equities. And remember how each player delivers something different? With high yield, you get the opportunity for – wait for it – higher yield, but you’re taking on more risk than in other fixed income categories. And the large cap equities provide inflation hedging properties with a moderate yield and higher risk.
And then we have our final team member, floating rate notes. Our fund FLOT invests in short term investment grade bonds with a floating rate coupon. The majority of bonds in FLOT have a coupon rate that resets every 1 or 3 months, so with this exposure, you have a player on your team that tends to react more quickly to changes in short-term interest rates.
Now, investors should consider their own risk tolerance when assessing whether to add these exposures to their portfolios. But I use this example to illustrate that it is possible for investors to seek out income while still managing concerns regarding rising interest rates and inflation. Considering a multi-asset “team” approach with new “players” is just one way to create opportunities for yield in even the most challenging of environments.
Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. The Funds are subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments.
Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.
Del Stafford, CFA, is a Managing Director and Global Head of iShares Product & Investment Consulting, a group that consults directly with investment advisors to provide in-depth market and product expertise for iShares offerings, as well as customized portfolio consulting support. In this role, his team conducts bespoke client portfolio analyses to assist with asset allocation, risk evaluation and portfolio structure decisions. Del joined iShares in 2008, then part of Barclays Global Investors (BGI), which merged with BlackRock in December 2009. Del spent over 16 years at The Vanguard Group, where he recently worked with the firm’s current and prospective defined benefit plan clients to structure custom investment solutions. He also worked as Senior Portfolio Manager within Vanguard’s Fixed Income Group, with responsibility for managing institutional, separately managed and stable value portfolios. Del holds the Chartered Financial Analyst® designation and is a member of the CFA Society of San Francisco. He earned an MBA from LaSalle University and a BS in finance from Bloomsburg University.