Bond investors are bracing for the Federal Reserve’s highly anticipated decision on whether to raise interest rates expected Thursday afternoon.
Fixed-income strategists have warned that a potential rate hike could prompt a Treasury selloff, particularly in the short-term maturities, such as the two-year Treasury
which are most vulnerable to changes in the Fed-funds rate.
Read more: The Fed’s decision on interest rates could rock these 6 markets
Here are some ways to prepare your bond portfolio for a rate hike:
1. ‘Ladder’ your portfolio
A bond ladder is a portfolio of individual bonds that mature on different dates. Laddering practically means distributing the bonds in a way that maturities are equally divided. This strategy is best for investors with a long horizon who don’t want to play the game of waiting to see when rates will rise.
“By staggering maturity dates, investors avoid getting locked into a single interest rate,” Kathy Jones, chief fixed-income strategist at Schwab Center for Financial Research, said in a research note.
Under this strategy, every year around 20% of the portfolio should mature and get reinvested, taking advantage of potential rising rates, Jones said.
Here’s a good explanation of bond laddering and its pitfalls.
2. Buy long-term bonds
If the Fed hikes rates, intermediate- to long-term bonds may actually rally, driving prices higher and yields lower.
The reason is that longer-term Treasurys, such as the 10-year note
, are more sensitive to inflation and growth expectations, rather than Fed-rate hikes, Anthony Valeri, investment strategist for LPL Financial, said in a note.
“A rate hike coupled with hawkish rhetoric could actually lead to lower 10- and 30-year Treasury yields,” Valeri added, amid low inflation, a strong dollar, and China growth uncertainty.
That is what happened in the 1999 and 2004 hiking cycles long-term yields rose in the short term but eventually fell again, as the following chart shows.
3. Sell the ‘belly’
The so-called “belly” of the yield curve includes Treasurys with maturities around five years. The yield curve is a chart depicting the difference between short-term and long-term interest rates.
Typically after a rate hike, short-term yields rise and the spread, or difference in yield between short and long-term maturities, shrinks. That’s when the yield curve is said to flatten.
In a flattening scenario, the belly of the curve sees the most volatility. So, a strategy to minimize volatility involves balancing a portfolio between short and long-term holdings and eliminating the medium-term maturities around five years, i.e. ditching the belly.
Here’s an explanation of how traders typically trade in the so-called belly of the yield curve.
View more information: https://www.marketwatch.com/story/heres-how-to-prepare-your-bond-portfolio-for-the-feds-interest-rate-hike-2015-09-17