After lying dormant for years, interest rates are beginning to rise again, both in the United States and abroad.

In addition, credit spreads are at multi-year lows and are expected to widen as we reach the late stages of the credit and economic cycles.

What should advisors and clients be thinking about in this new rising rate/widening spread environment?

Here are five factors to consider:

1. Active wins over passive. When rates fall, it is the income equivalent of “a rising tide raises all boats.” But when rates rise and/or spreads widen, actively managing a bond portfolio becomes more important. There are certain investments held in bond indexes, such as longer-duration Treasuries or certain high-yield bonds, that advisors and clients should seek to avoid, and this is best done by using active management.

2. Balance income portfolios between duration and “opportunistic credit” strategies. The past six to seven years have seen the introduction of opportunistic credit or unconstrained bond managers. These managers are not limited to investing in a particular sector of the income market but rather can move and re-allocate among multiple sectors, depending on where they see opportunities. Depending on the manager, many of these managers run very short-duration portfolios and focus more on relative value credit spread opportunities. As such, they can play a nice complement to the income portfolio’s more core duration strategies, such as investment-grade or longer-duration bonds. Once again, active management is key.

"While rising rates can present increased risk to income portfolios, advisers can help clients manage this risk through intelligent portfolio construction and an increased use of active management," says Scott Welch, chief investment officer at Dynasty Financial Partners.

3. Bonds beat funds. It is important to remember that assuming no default, there really is no price risk in bonds that are held to maturity, because the price will always revert to par. This is not true with bond funds, where the investor owns shares in the fund but not the underlying bonds themselves. Fund investors can and do face price risk when buying into and selling out of funds that they do not face if they own the underlying bonds or, more commonly, own the bonds via a third-party manager in a separately managed account. And remember, if rates rise, those maturing bonds can be rolled over into higher-yielding new bonds.

4. Go with shorter over longer duration. As rates begin to rise, advisory clients should look to shorten the average duration (i.e., the price risk associated with a change in rates) of their income portfolios. One reason is that shortening the duration will make their portfolios less price sensitive to an upward change in rates. In addition, the returns they can earn on shorter-term strategies will rise as the yield curve goes up, assuming that the whole yield curve is rising and not just the long end, which is what is happening in this market environment. In fact, the environment in the United States is that of a flattening yield curve, as short-term rates are rising more quickly than long-term rates, so most investors are not being appropriately compensated for taking on longer-duration risk versus what they can earn with shorter-term instruments.

5. Think hard about high yield. The natural inclination for most advisory clients is to think about de-risking their income portfolios as rates rise, but high yield presents a more complicated situation. On the one hand, the higher coupon rates associated with high-yield bonds makes them less sensitive to upward movements in rates (i.e., a bond with a higher coupon rate has a lower duration than a bond with the same maturity but a lower coupon). On the other hand, companies issuing high-yield bonds may have difficulty meeting their obligations or refinancing as rates rise, thereby increasing default risk. This market environment is a good example: High-yield credit spreads are very low or tight, suggesting significant price risk should those spreads begin to widen back out, which they will as the credit and economic cycles run their course. So, advisory clients should be very wary of allocating new dollars into high yield. At the same time, even at these narrow spread levels, investors are still being paid a premium yield, versus the actual and predicted levels of default risk, because corporate balance sheets are generally in pretty solid shape. So, those who are already allocated to high yield don’t necessarily need to rush for the exits, though they should be identifying where those exit points are. This complexity, as well as the makeup of most high-yield indexes, makes a strong argument for always using active versus passive management when it comes to high yield.

In summary, while rising rates can present increased risk to income portfolios, advisors can help clients manage this risk through intelligent portfolio construction and an increased use of active management. As with equity portfolios, a key component of risk reduction is prudent and thoughtful diversification.

This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.

Scott Welch

Scott Welch

Scott Welch is the chief investment officer at Dynasty Financial Partners in New York.