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In its last meeting of 2018, the Federal Reserve said it would raise short-term interest rates by 0.25%. While the central bank indicated that it could ease up on rate increases in 2019 due to weakening in the economy, we could see further emphasis on rate increases this year if the data starts to signify a strengthening economy.
When interest rates are rising, many investors shun longer-duration bonds in order to lessen the risk of their bonds falling in value due to rate hikes. However, certain longer-duration bonds may offer a measure of stability during times of market volatility. So how can investors prepare their portfolios for both rising rates and volatility? We believe one approach is to pair short-duration bonds with low volatility stocks.
The long and short of duration
When interest rates rise, bond prices generally fall, and vice versa. Duration measures how sensitive a bond is to this dynamic, with longer durations representing higher sensitivity.
The Invesco Global Solutions team reviewed the results of the Custom Portfolio Analysis (CPA) on 632 financial advisor model portfolios examined during the third quarter of 2018. During this process, we discovered that 92% of these model portfolios had a shorter duration than their benchmark, making them less sensitive to interest rate risk.
This isn’t a bad thing — in fact, during the past quarter, our team reduced the duration exposure in the multi-asset portfolios that we manage due to the risk of rising rates. But when such a move is made in isolation, it may have unintended consequences.
For instance, short-duration bonds have historically been more correlated to equities compared to high-quality, long-duration bonds (such as long-dated US Treasuries), which have had a strong negative correlation to stocks. Therefore short-duration bonds may provide less shelter against cyclical volatility in the stock market. As part of our Custom Portfolio Analysis service, we perform a stress-test on advisors’ portfolios, and we found that four out of five portfolios would be vulnerable to an “early contraction” scenario — which will be the next phase of the economic cycle following the current expansion.
Analyzing stocks and bonds together
In our view, a thoughtful analysis of a portfolio’s equity sleeve may be warranted when duration is shortened in the bond sleeve. We believe that, in the right measure, exposure to the Low Volatility equity factor can help bring duration-lite portfolios into balance for volatile markets. Stocks with this factor have historically demonstrated lower volatility than other stocks in the same asset class.
As bond investors adapt to rising rates, Invesco Global Solutions can help financial advisors take steps that may ensure that duration avoidance doesn’t imperil portfolio outcomes as the economic cycle matures.
Blog header image: Konstantin Kolosov/Shutterstock.com
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes that may explain differences in returns. There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain factors. Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. Factor investing may underperform cap-weighted benchmarks and increase portfolio risk.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Funds’ return may not match the return of the Underlying Index. The Funds are subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Funds.
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There is no assurance of low volatility.
Correlation is the degree to which two investments have historically moved in relation to each other.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.
Christopher Hamilton, CFA®, CAIA
Head of Portfolio Advisory
Invesco Global Investment Solutions
Christopher Hamilton is Head of Portfolio Advisory for Invesco Global Investment Solutions. In this role, Mr. Hamilton leads Advisory Solutions efforts in the wealth management intermediary marketplace, with a focus on providing multi-asset portfolio construction research and guidance to financial advisors and wealth management platforms. As part of the Invesco Global Solutions franchise, he works to deliver in-depth portfolio research, analytics tools and investment solutions to investors across North America.
Prior to assuming his current position, he was part of the Wealth Management Intermediary strategy team, focused on developing multi-faceted distribution strategies for key clients across multiple channels. Prior to joining Invesco, Mr. Hamilton was a portfolio manager for U.S. Trust, focused on building out asset allocation and portfolio construction frameworks, and leading manager selection efforts for high-net worth individuals and institutions. He was also director of business analysis for Phillips 66, where he engaged in merger, acquisition and divestiture efforts, as well as capital market activities for the organization.
Mr. Hamilton earned a BA degree in economics from the University of Illinois at Urbana-Champaign, and an MBA from Rice University. He holds the Series 7, 63 and 66 registrations. He also holds the Chartered Financial Analyst® (CFA) designation, the Chartered Alternative Investment Analyst (CAIA) designation, and is a member of the CFA Society of Houston.
Vice President of Portfolio Advisory
Invesco Global Advisory Solutions
Dan Adams is Vice President of Portfolio Advisory for Invesco Global Advisory Solutions. In this role, Mr. Adams is responsible for Advisory Solutions efforts in the US retail and institutional marketplace, with a focus on providing multi-asset portfolio construction research and guidance to financial advisors, wealth management platforms and institutions. As part of the Invesco Global Solutions team, he delivers in-depth portfolio research and analytics tools to investors across the country.
Prior to joining Invesco, Mr. Adams spent more than nine years working for Credit Suisse and Evercore ISI in New York and London in HOLT/Multi-Asset Research and Institutional Sales roles.
Mr. Adams earned a BA degree from Loyola Marymount University in Los Angeles.