Responding to Interest Rate Changes

October 30, 2012

interestratesFixed income investors are concerned about low yields and the fact that interest rates will eventually rise. We don’t attempt to forecast interest rate direction. Instead, we reposition our fixed income portfolios into different areas of the bond market that are currently most attractive.

Here are some of the options available to us in different interest rate environments:

If rates rise

We could increase allocation to short-term funds, which remain fairly stable when interest rates rise. So long as defaults stay low, we could use floating rate funds, which can be more insulated from the negative impact of rising rates. We can invest up to 30% of our flexible fixed income portfolios in low volatility balanced funds, which have limited exposure to bonds and aren’t as affected by interest rate fluctuations. August 2006 is one example: in the face of rising rates, NoLoad FundX’s Monthly Flexible Income Portfolio incorporated funds with shorter maturities, and had exposure to floating-rate funds and low-volatility balanced funds. However, sticking with this allocation through 2008 would have been disastrous. Instead, in 2008 the MFIP was very defensive.

If rates fall

Rates have been falling recently so the current portfolio is an example of how the MFIP could be positioned. The portfolio has a significant allocation to reasonably high credit quality, mid-duration bonds that continue to do well as rates decline. We can extend duration and credit quality as we see opportunities. We also recognize that the lower rates are, the less room they have to decline further. Our broad diversification means that we’re not dependent on continued rate declines to generate a reasonable return.

If rates remain low and stable

We can continue to take advantage of credit spreads, collecting hefty dividends from higher yielding corporate bonds and non-agency mortgage debt. We could also include higher yielding securities from foreign companies and emerging markets. We may use low volatility balanced funds which aren’t as correlated to the bond market.

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