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Positioning Bond Portfolios for Future Rate Hikes

While swings in global asset prices have been unnerving to many investors, we remain focused on the largest potential story for global markets outside China: an inevitable shift in monetary policy by the Federal Reserve (Fed) in the coming months. While the Fed ultimately decided to hold off on hiking rates in September, we remain convinced that a rate hike is likely by the end of 2015. However, while some advisors may speak about rising rates casually, we believe it’s important to review what rates may be most impacted when the Fed finally does raise rates.

All Interest Rates Are Not Created Equal

The two most difficult questions about preparing for a Fed rate hike have regarded timing and targeting which rates may be poised to rise the most. When the Fed hikes rates, this shift in policy will have ripple effects across the short end of the yield curve as interest rates readjust. This is precisely what we saw over the last several weeks. Leading up to the September 17 Federal Open Market Committee (FOMC) meeting, rates on 2-Year U.S. Treasury notes rose by more than 24 basis points (bps) from their lows in mid-August.1 On Thursday and Friday, these rates fell by 13 bps when the Fed delivered no change and “dovish” commentary. However, the ultimate impact on the longer end of the yield curve may be what matters most to many bond investors. In many ways, the impact of a change in Fed policy on the long end of the yield curve remains open for debate.

Long Bond Remains Low for Longer: One analyst camp says that long-term rates needn’t rise because falling commodity prices and slower global growth will keep inflation constrained. Therefore, with a major determinant of interest rates not necessarily changing with the Fed, rates can remain low.

End of Secular Bond Bull: The other camp believes that any Fed change is an endorsement that the historically low period of inflation may have bottomed, and therefore increases in inflation may be just around the corner as the economy continues to expand.

In our view, the risks of being wrong on inflation and longer-term interest rates far outweigh the “benefits” of being right. In the most recent sell-off in global equities, U.S. interest rates declined only modestly on this significant “risk-off” move—one sign there may be limited gains to be had from long...