There’s evidence that a hike in interest rates by the Fed is imminent. But what does this mean for your investments?
Unfortunately, interest rate risk has increased recently. Looking at modified duration, which measures the value of bonds in response to a change in interest rates, there’s evidence that sensitivity to interest rate changes is at a historical high. As a result, investors may find it hard to recover any capital lost from interest rate increases.
But there are some ways to guard against this.
We compared two approaches to mitigating interest rate risk available through index-based solutions. They both have the goal of limiting interest rate risk while keeping exposure to credit premium.
The first solution is simply to limit one’s portfolio to short duration bonds. This will reduce interest rate risk, but it will also reduce the credit premium.
An alternative is to eliminate interest rate risk altogether through interest rate hedging, choosing a benchmark with embedded short selling of Treasury futures with durations similar to the underlying corporate bonds. Investors can thus achieve duration-neutrality and harvest full credit premium.
We think interest rate hedging is a promising strategic solution for an environment of rising interest rates. When we looked at the data, past performance supports this.
Investors should be aware that past performance is not an indicator of future results.