Managing Bond Risks in a Rising Interest Rate Environment

Since their low in mid-2016, longer-term interest rates have more than doubled. While that may sound ominous, admittedly the increase has been from a very low level -- ten-year Treasury yields, for example, have risen from below 1.50% to above 3.00%. Yet low interest rates mean higher risk, as the mathematics of bonds include both coupon (interest) income and price change. When coupon income is quite low, as has prevailed for the last several years, there is little to cushion periodic price gyrations.

Managing Duration Risk

The impact of changing interest rates on bond prices is, perhaps, the largest risk to be addressed, and is quantified in a measure commonly called “duration”. Madison adjusts the duration risk of our client portfolios based on our intermediate-term outlook for movement in the general level of interest rates. The economy has been recovering from the “Great Financial Crisis” of 2007-2009 for several years. While this recovery has been uneven, the general trajectory of economic growth has been upward for some time and the U.S. continues to enjoy the fruits of one of the longest economic expansions since World War II. To stimulate this recovery, the Federal Reserve (Fed) has maintained a monetary policy regime of low interest rates designed to encourage ongoing growth. In 2016 we began to become concerned that the time had come for the Fed to begin withdrawing “the punch bowl”, leading to a period of generally rising interest rates off of a very low base. Our indicators became overwhelmingly negative for the bond market, and as a result we positioned our client portfolios with significantly less duration risk than the market in general to mitigate the effects of rising interest rates ahead. This positioning has paid off for our clients, resulting in a consistently favorable portfolio duration effect on performance compared to our passive benchmarks. As interest rates have risen to key levels, we have begun to add risk back to client portfolios, but retain, for now, our conservative positioning as it relates to duration/interest rate risk. The chart below highlights various duration adjustments that we’ve made across Madison Intermediate Government/Corporate bond accounts since 2016. Note that adding duration is advantageous as interest rates rise; reducing duration is advantageous when interest rates are in decline. Looking ahead, we believe interest rates will continue to rise for now until the economy shows signs of slowing and inflation measures begin to stabilize. While we expect the Fed to continue to boost short-term interest rates, the risk/reward proposition is beginning to at least become more interesting.