Managing interest rate risk in fixed
income portfolios

Fixed income has long been a staple of investors' portfolios, typically providing both income and capital appreciation. Characteristically, when interest rates fall, bond prices rise, which benefited investors during the past few decades of declining rates. This inverse relationship, known as interest rate, or duration, risk, has important ramifications for investor portfolios.

 


An important relationship

With interest rates hovering around historic lows, there’s little room for rates to fall further. This floor puts fixed income investors at significant risk, because when interest rates again rise, the price of an investor's bonds are apt to fall, eating away at portfolio returns. Even incremental moves in rates can have measurable impact for investors.

For every year of portfolio duration, a bond’s price moves roughly the same degree in the opposite direction to a change in interest rates.

What happens to bond prices when rates rise?

Hypothetical illustration of the effects of portfolio duration

Change in bond prices if rates spike 1%

Long/short investing as a response to rising rates

When a fund manager can invest both long and short, not only are there more opportunities to choose from but the fund can be positioned to potentially limit the losses resulting from rising rates. For instance, returns of a long/short credit fund are generated largely from buying bonds of strong borrowers and shorting bonds of poor borrowers. The long/short strategy allows investors the potential to profit from both positive and negative views on individual credit securities rather than relying on the benefits of falling interest rates.

In addition, a long/short fund can be managed so that its net exposure (a measure of market sensitivity) is net long, net short or even market neutral. Through this positioning, the portfolio manager seeks to capitalize on – or protect against – broad market moves as they see fit. While a fixed income long/short strategy does carry risks for significant losses, including in some cases, total loss of principal, the flexibility afforded by a long/short strategy can lead to decreased correlation to broader markets and lower volatility.