How can I manage interest rate risk in the face of FED tapering?

Interest rate risk has largely dictated the level of returns bond investors have received since 2009. We are still in the early stages of a recovery cycle so sharply higher rates are unlikely,  but there are risks on the horizon.

In our opinion, the potential unwinding of extraordinary measures, and the increased focus on Central Banks’ forward guidance, may ultimately lead to higher volatility within fixed income.

Portfolios with higher duration will perform better than those with lower duration when yields are falling, but they will underperform when yields rise.

Prior to Federal Reserve Chairman Ben Bernanke’s comment in May 2013 about the possibility of tapering, yields on the 10-year US Treasury had fallen significantly as Central Banks implemented accommodative monetary policies.

Riskier assets would have witnessed even greater yield compression. Over that time period, and ultimately over the last 30 years, the majority of fixed income asset classes benefited from lower yields. As a result, most asset managers willing to increase interest rate or spread risk versus their benchmarks, would have achieved substantial outperformance.

Case study: Managing a steepening yield curve – short dated bonds