Bond investors are increasingly becoming concerned that rising inflation will lead to even higher interest rates. The cause for concern became even more acute after the US reported that in April the rate of inflation over the past year jumped to 4.2 per cent from 2.6 per cent in the prior month — the highest level since 2008.

Many investors therefore fear that the US Federal Reserve may be forced to tighten monetary policy sooner than planned to contain inflation, thus paving the way for further upward movements in benchmark interest rates.

Consequently, some individual investors are hesitant to make bond purchases at this time as they fear that higher interest rates on the horizon will erode the value of their bond portfolios. However, investors should be reminded that bonds are intended to be medium- to long-term investments and therefore cash flow, not trading gains and losses, should be the key consideration for individual investors. Nevertheless, there are numerous strategies an investor can employ in the face of a rising interest rate. Some of these are:

(1) Buy bonds with shorter maturity or call dates.

(2) Buy bonds with variable/floating coupon rates.

(3) Construct a laddered portfolio of bonds.

(4) Explore specific structured notes (Equity linked notes).

Shorter dated bonds

Shorter dated bonds are less sensitive to interest rate movements than longer dated bonds. In other words, the price or value of short-term bonds will fall less than the value of long-term bonds for a given increase in interest rates. An investor can reduce price risk by buying short-term bonds and enjoy the added benefit of a return greater than that otherwise available by simply keeping funds in cash or investing in a money market instrument. However, yields on these instruments will still be relatively lower than those earned on longer dated bonds.

Floating rate bonds

Floating rate bonds are popular in a rising interest rate environment and offer investors the prospect of higher coupons after each interest reset. The coupon rates on floaters are usually quoted as a spread to a variable benchmark rate (such as US treasury yields) and periodic coupon payments will increase as the variable benchmark rate increases.

Laddered portfolio

An investor can also purchase a series of bonds with different maturity dates to construct a laddered portfolio. A laddered portfolio can facilitate an ongoing return of principal as the bonds mature, which can then be reinvested at higher yields as rates rise. Buying several different bonds to construct a laddered portfolio can, however, be a very expensive and tedious exercise.

Structured notes

Finally, investors can buy structured notes, particularly equity-linked notes, to take advantage of increased market volatility that rising interest rates normally cause. Higher market volatility usually translates into larger contingent coupons on structured notes. Investing in structured notes, however, exposes the investor to significant risks of loss and, as a result, is not suitable for everyone.

Structured notes are more suitable for sophisticated individuals with high net worth and institutional clients due to their complexities, deal sizes and inherent risks.

As always, be sure to consult with your financial practitioner to determine if an investment is suitable for you.

Eugene Stanley is the VP, fixed income & foreign exchange at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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