Limiting Risk of Rising Rates

An exercise I find useful — certainly more useful than trying to predict the future — is to ask myself, what are the main risks to my portfolio? Sometimes we have more riding on one potential outcome, or at risk from another, than we realize.

The list of major risks is long, but higher-than-expected inflation and interest rates are pretty high up. Other than underweighting the mega-cap tech stocks for fear they will fall back to earth, the biggest risk I’ve chosen to protect against over the past few years is rising rates

I’m not predicting higher rates. I’m not shorting Treasurys. If rates stay at current levels or fall, my stock funds, and thus my overall portfolio, should do fine. It’s just that my bond holdings, geared to limit rate risk, would lag the overall bond market index if rates fell (bond prices rise when rates go down). That’s because the index is heavy on Treasurys — since Uncle Sam is such a prodigious borrower — and has significant interest rate sensitivity. But that’s a risk I’m willing to take. I don’t want both my stock holdings and my bond holdings excessively vulnerable to an unexpected increase in rates.

Here’s my approach to the 33% of my portfolio that’s in bonds. It’s broadly diversified — arguably overcomplicated, but I have many retirement accounts and an emergency fund. It’s duration (a measure of interest rate sensitivity) is just 2.7 versus 5.9 for the iShares Core U.S. Aggregate Bond ETF (symbol: AGG), which tracks the overall investment grade bond market. To illustrate duration, the ETF would lose (or gain) 5.9% for a 1 percentage point rise (or fall) in interest rates. That’s more fluctuation than I’d like, though some experts say that with a recent starting yield of 4.6%, the risk/reward in the core bond index fund is attractive.

• TIPS and Treasury bills held to maturity. I like the idea of getting my money back, guaranteed. My two T-bills yield north of 5%. But only with my Treasury Inflation Protected Securities am I guaranteed to get everything back adjusted for inflation. The latter will do better than the conventional Treasurys if inflation exceeds expectations.
• Shorter-duration, actively managed bond funds. My preference for active bond funds got an unexpected endorsement in late January from Vanguard Global Chief Economist Joe Davis. Vanguard is known for index funds and for preaching the advantages of indexing, but it offers some actively managed funds. Davis wrote that active bond fund managers have greater ability to add value in an environment where rates are steady or rising. Active managers tend to emphasize corporate or mortgage-backed securities, which yield more than Treasurys but have greater credit risk. And, in keeping with my preference, many actually managed core bond funds also pose less rate risk than the index ETF because they have chosen to limit duration. (You can find a fund’s duration on the asset manager’s website or on Morningstar.) Of course, with that positioning, such funds would lag if corporates underperformed, like during a recession, or if rates declined, boosting longer duration assets. You can also buy shorter term bond ETFs and target a rate sensitivity you can live with.
• I Bonds. I’ve got a small position and likely will add another $10,000 this year. I want to have a permanent, substantial position in my emergency fund. The total yield is not so enticing right now, at 4.3% on my current holdings through April, but experts like David Enna at the very informative Tipswatch.com say the 1.2% permanent fixed rate is attractive. That fixed rate could even be higher for I Bonds issued this May, which is when I’ll likely buy. If inflation spikes as it did in 2022, the twice-yearly inflation adjustment on I Bonds would soar, too. Their value doesn’t fluctuate, and you don’t pay taxes on the interest until you sell. It would be advantageous to hold them at least until I retire in five or so years.

Since 2022 I’ve developed the attitude that I’d rather 1) lock in generous rates than float with them in longer duration bond funds and 2) tilt my risk more toward corporate and mortgage-backed credit than pure interest rate fluctuations, which seem so random. If I lose money in a bond index fund just because rates rise, I feel like I didn’t deserve it. I used to invest mainly in intermediate Treasury funds for their high quality but watching them tank in early 2022 was too much for me, as I wrote here and here.

Because of these choices, I do deserve to lose out if rates fall, but I’m determined not to get burned if they rise.