Rates are still low and could be for some time, but with some financial uncertainties out of the picture, this might be the time for investors to consider the possibility of an eventual rate rise.
At least that is what Charles Dolan, senior investment strategist for BNY Mellon Investment Strategy and Solutions Group, suggests in a recent white paper he co-authored with ISSG strategist Chris Harris.
“This is not so much a strategy as a suggestion of a way to look at fixed-income portfolios over a long horizon,” Dolan said in an interview. Dolan specifically looks at a five-year horizon using Monte Carlo simulations of certain economic scenarios that could pose particular risks.
“Everybody knows the Fed’s on hold,” so it might be the time for investors to start taking another look at their portfolios ahead of a possible rate rise “while there is still a little spread left in things.” He said investors might want to ask themselves, “What would you do if you had to hold out for five years?”
The report focuses on a specific portfolio from a particular point in time that serves an example of how the that question could be addressed, at least by investors for whom the suggestions might be appropriate. Dolan said he had in mind an institutional investor who is heavily overweighted in a particular sector. “One we think is particularly overweighted now is Treasuries,” Dolan said.
The report suggests how mortgage-backed securities, inflation-linked bonds, municipal bonds, and a diversified credit exposure including floating-rate bank loans “potentially may reduce the amount of uncompensated duration risk in many fixed-income portfolios.”
When asked why now is the time to consider this Dolan said, “We think a lot of the storm clouds are clearing.”
He cited as one example European Central Bank president Mario Draghi’s summer statement about how he would do anything to save the euro. “That removed some of the tail risk there, even though things are far from settled,” said Dolan.
“When the economy in China started to improve, one big tail risk went away, and when Obama regained the White House it became clear that there was a somewhat more conciliatory tone among all the players in Washington,” he added.
Dolan acknowledges that some notable risks continue to pose uncertainty, such as the fiscal cliff, although he said this risk has “diminished relative to what it was, say, six months ago.”
Kept in mind in the paper is the fact that “a lot of people have had a pretty good ride...since the crisis. There has been a huge divergence between stocks and bonds, bonds because of the Fed and because of the tail risks out there in the environment. Bonds haven’t really sold off, especially Treasuries, nearly as much as stocks. People are sitting in a pretty good situation” and Dolan said he knows it is “difficult for people to sell all their duration right now.
“From a governance perspective it’s difficult. Most people’s allocation doesn’t give them that kind of flexibility. For active managers most people don’t take huge duration bets relative to a benchmark anymore because that’s worked out badly for people in the past.
“When you look at the Monte Carlo simulations and when you look at yields, it made a compelling case,” he said of the diversified fixed-income suggestion in the report.
Dolan said that although the research for the paper had to be done over time, he recently double-checked how it would fare in an updated market environment and found it to still be effective.
The paper also presents two other options: an interest rate swap approach for investors with derivatives programs already in place, and information on how investors can buy options for pay for a defined interest rate in exchange for a market-based rate.
