Separating Sources of Income from Price Appreciation in Fixed Income Portfolios

For years there has been discussion around separating alpha from beta in search of better returns from active investment management. However, now is the time to start talking about separating the sources of return in fixed income portfolios between income and price appreciation. The Fed is graciously giving investors plenty of warning time about a possible rise in interest rates (and resulting decline in bond prices.) The clearest indication is from the Fed itself in its quarterly summary of economic projections made by Federal Reserve Board members and Federal Reserve Bank presidents. A table compiled from data in the report showing the projected Federal Funds Rate is below:

fed projections2

When interest rates rise, bond prices fall. This is called interest rate risk. If the bonds fall more in price than the yield, or income received, investors suffer a loss on their fixed income holdings. With rates currently being artificiality held down by the Fed, there is likely only one direction that interest rates will go (hint: up!) when the Fed stops their policy of continued intervention. From the chart above, 2015 seems to be the year. However, don’t rely on today’s fixed income yield to cushion any fall in bond prices that might occur between now and then. The current yield on the industry bellwether Barclays Aggregate Index is a meagre 1.56%, as represented by iShares Barclays Aggregate Bond ETF (Ticker: AGG). The risk of holding this investment, relative to its yield, is high. The effective duration of the ETF is 4.28. Thus, a 1% rise in interest rates would mean a loss on the underlying fixed income holdings of the fund equal to just over 4%, enough to wipe out about two years of income. Larger increases in rates means larger losses. In fact, losses are limited only by how much rates can rise while potential gains are limited by how low rates can go, and there isn’t much room for rates to go lower.

As a result, investors need to start thinking about how reduce their exposure to interest rate risk by separating the sources of income in their portfolio from the sources of capital appreciation. In Part II of this post, we will present some ideas about the various ways investors can do this.

Note: This post originally appeared on Alternative Strategy Partner’s blog page on October 8, 2012.

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