Still spooked by the uncertainty of the stock market? Because of the looming threats of inflation, rising interest rates, and geopolitical uncertainty, many conservative investors are still leaning more toward fixed-income investments. However, investors need to realize that there is inherent risk in the bond market should interest rates begin to quickly rise. The question then becomes, what is my exposure to rising interest rates and how can I anticipate or measure the impact rising rates would have on my portfolio?
As a way of addressing these concerns, I recently constructed a portfolio for a very conservative investor who was seeking a yield greater than what they could obtain in money market investments (see Table). They were also interested in minimizing the risk of the portfolio and lowering the expenses of managing the portfolio.
In addition, the 1-, 3-, and 5-year net pretax portfolio returns were 5%, 6%, and 6.9%, respectively. Also, the average volatility of the portfolio relative to the market as measured by the S&P 500 was less than one fifth of the market index.
Now, the question becomes, what would happen should interest rates suddenly move up 100 basis points? Such a case would be very unlikely given the sluggishness of the current economy, but the question still remains: What if?
Based on a portfolio duration of 3.2 years, should rates increase by 1% or 100 basis points, the value of the underlying portfolio would decline by about 3.2%. So, in a worst-case scenario, if there was $1 million invested in such a portfolio, a 5.1% yield or $51,000 in income would be partially offset by a $32,000 decline in the value of the portfolio. In this case, the investor would still be ahead of the game by $19,000 or 1.9%. Additionally, if interest rates were to decline, there may be some capital appreciation realized on the portfolio, but chances are this would not occur either.
The bottom line:
Interest rates have nowhere to go but up. This has steadily been occurring. Therefore it is important when selecting fixed-income investments to concentrate on the credit quality, duration, maturity, and yield of the investments within the portfolio.
and his partner,
Harris L. Kerker, are principals of
the Asset Planning Group in
Miami, Fla, specializing in investment,
retirement, and estate planning.
Mr. Kosky teaches corporate
finance in the Saturday Executive and Health Care
Executive MBA Programs at the University of
Miami. He welcomes questions or comments at
800-953-5508, or visit www.assetplanning.net.
Thomas R. Kosky