Active Management of Fixed Income Risk


Active Management of Fixed Income Risk

While bonds are presumed to be a safer investment than stocks, investors are still faced with a variety of risks when they buy a bond. When these risks surface, the price of a bond may fall and future interest payments may be put in jeopardy, causing an adverse impact on your portfolio. Passive buy-and-hold strategies or ETFs, while common, often fail to address all risks within fixed income.

Active fixed income management, on the other hand, sets out to manage the different risk characteristics of the fixed income market. With active decision-making within a portfolio, a portfolio manager can respond to market conditions, differentiating them from a passive approach. Below, we explore some of the different types of risk an active manager can address.

INTEREST RATE RISK

Interest rate risk is the impact an investment has to changing interest rates. It can be broken down into two types. The first is absolute interest rate risk, this is the level of interest risk a client is willing to have in their portfolio. For Reinhart Fixed Income strategies, this is set by the client, often in consultation with their financial advisor. The other type, relative interest rate risk, includes the amount of interest rate risk a manager chooses to take relative to a benchmark.

When actively managing interest rate exposure, a manager aims to take gains during falling rate environments while protecting principal in rising rate environments. This active management method can help minimize the opportunity cost of locking in lower rates for longer maturity periods during rising rate times.

CREDIT RISK

Credit risk is the likelihood of an individual bond in a portfolio experiencing financial distress to the point that either spreads widen or the bond defaults. A combination of quantitative and qualitative analyses can often identify opportunities (or help avoid risks) on individual bonds. By concentrating on building a portfolio of high quality names, a manager can develop a margin of safety and by continually monitoring the investments, they should have time to recognize and remove a position from the portfolio if it were to start experiencing distress.

STRUCTURE RISK

In its simplest terms structure risk is the callability of a portfolio. When an issuer has the ability to redeem a bond early, it brings a level of uncertainty to a fixed income portfolio. For example, if a 10 year bond can be called after five years, the income you may have been counting on will be adversely impacted if that bond is called and you are forced to reinvest in another bond with a less favorable interest rate.

LIQUIDITY RISK

Liquidity risk is the possibility that an investor will not be able to sell a bond for market value. Liquidity risk is measured using the bid-offer spread, or the difference between what someone can sell or buy a specific bond. When an investment has a high level of liquidity the bid-offer spread will be small but as the amount of liquidity decreases the bid-offer spread widens. Managing the liquidity and variance in bid-offer spread is one of the ways an active manager can maneuver in changing market conditions and add value to a client’s portfolio.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”), which also includes the Madison Scottsdale office. MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.

Madison Investment Holdings, Inc. acquired the fixed income management assets of Reinhart Partners, Inc. on June 11, 2021 and now employs the Investment Team that previously managed the assets at Reinhart. The Investment Team manages the assets using substantially the same strategies and objectives as at Reinhart. Performance information dated prior to the purchase reflects that of Reinhart Partners, Inc.

Unlike individual bond positions, managed bond strategies have ongoing fees and expenses.