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​Keep Your Bonds Safe with These Six Questions

​By Mark Murphy, Chief Investment Officer, Raffa Wealth Management

In March, the Federal Reserve raised its benchmark interest rate a quarter percent. This hike came only three months after the Fed’s last rate increase, and the central bank indicated that further increases were likely to come later in 2017. Because bond prices fall when interest rates rise, the bond allocation in a reserve would likely experience capital losses. And this begs the question: How does a nonprofit mitigate potential losses in its reserves resulting from rising interest rates?

Along with maintaining a fixed-income strategy that minimizes portfolio losses specifically when interest rates rise, a nonprofit can also ask its investment advisor these six questions related to its investment policy statement (IPS) to ensure the safety of its bonds.

Does our IPS have an average maximum maturity? An average maturity is a dollar-value-weighted measure of all the bonds’ maturities in the portfolio. A maximum average maturity then places a limit on how long the total bond allocation’s collective maturity can be. It creates a clear boundary for the investment advisor, and it limits the risk a portfolio can take on. A common maximum average maturity is eight years. Without this, the portfolio could be longer-term focused, and these are much more sensitive to interest-rate changes than shorter-term bonds. As a result, longer-term bonds are more volatile and can experience significant declines from an asset class that should be providing stability. For instance, over the second half of 2016, long-term bonds as represented by the Barclays U.S. Government/Credit Long Bond index declined 6.70%, while the Barclays U.S. Government/Credit 1-5 Year Bond index declined just 1.01%.

Does our IPS call for an average credit-quality minimum? Bonds should serve the purpose of a counter balance to equity in a portfolio and provide stability. To that end, an average credit-quality minimum—ideally an average credit quality rating of A—should also be included in your IPS. Without a minimum credit quality, a fixed-income portfolio could be high-yield focused, which is much more volatile and equity-like than a high-quality, fixed-income portfolio. Recently, high-yield bonds as represented by the Barclays High Yield Bond Index have had a volatility level that is nearly double that of U.S. government bonds. This translates into times of significant trailing performance compared to a high-quality, fixed-income allocation.

Does our IPS require our fixed-income portfolio to be diversified among issuers and countries? As with equities, it’s important to have a fixed-income portfolio that is diversified amongst sectors and around the globe. Each sector—from mortgage bonds to asset-backed securities—reacts to economic news differently. Diversifying amongst the varying types of bonds reduces risk of the overall portfolio. Similarly, a best practice that improves a portfolio’s diversification is to have exposure to international corporate and government bonds. Approximately 70 percent of the total outstanding world debt is outside of the U.S., which provides a large set of investments that a U.S.-only portfolio would miss. Plus, as each country has its own yield curve, rates may be rising in one country and falling in another.

If our IPS includes investment in foreign bonds, are they hedged back to U.S. dollars? The role of fixed income in a portfolio should be to provide capital preservation and stability. But investing in international fixed income exposes the allocation to foreign currencies, which are much more volatile than bond prices. For example, the volatility of the Citi World Gov. Bond Index 1-30 year unhedged is 9.90%, which is more than three times volatile than the hedged version of the index. Therefore, to get the true exposure of the foreign bond holdings, they should be hedged back to the U.S. dollar to remove the currency fluctuations from the equation.

Is our fixed-income benchmark aligned with our fixed-income policy in our IPS? Benchmarking is an extremely important part of investing. It enables an investor to both compare performance to a neutral allocation and clarify whether or not value is being added by investment decision makers. Therefore, it’s important that the fixed-income benchmark that is used aligns with the overall fixed-income investment strategy. For instance, if a portfolio has a fixed-income policy that only allows for an average maturity of less than five years, but the Barclays Aggregate Bond Index is used, this is a misalignment—as the average maturity of this index is eight years.

Do our investment reports indicate compliance with our IPS? There are a variety of requirements and restrictions that are typically included in an IPS, from minimum and maximum thresholds for each asset class to credit-quality requirements. A board member or finance committee member is usually charged with ensuring that the investments in reports are in line with these IPS requirements. But in an effort to make that responsibility easier, nonprofits can request that their investment advisors include a statement in their reports, saying the portfolio is in compliance with the IPS, as well as itemizing specific IPS-related issues.

With interest rates still near record lows and the Fed eager to raise the Fed Funds rate, it‘s likely that interest rates are headed up. But getting affirmative answers on these six questions from your investment advisor ensures that the fixed income portfolio is invested in a way to combat a rising interest rate environment.

If you have any questions about this article, please contact Mark at mark@raffafinancial.com.

Reprinted with permission. Originally published by ASAE: The Center for Association Leadership (April 2017), Washington, DC.
Disclosure: There is no guarantee that any investment strategy, including those described here, will be successful. Any investment or investment strategy can lose money. Past performance does not guarantee or predict future results.  You should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Raffa Wealth Management, LLC.