How Do You Invest in Bonds When Interest Rates Rise?

Fixed Income Allocations

Fixed income investors are facing two cold fronts: A trifecta of tightening liquidity, slowing growth and high inflation; and sharply rising sovereign, investment grade and high yield bond yields. There has been nowhere to hide in traditional fixed income. The question being discussed with asset managers now is, what should we do?

Thus far, the knee-jerk reaction has been to reduce duration even as far as cash-plus, and shift to floating rate notes. But the majority of investment grade and high yield bond managers tow the line that at current yields, rate risk has been priced in, and spread risk has a sufficient cushion.

Their answer to the question "how do you invest in bonds when interest rates are rising" is "At these yields, does running a duration mismatch against your strategic allocation make sense?".

But there is a second answer coming from the doom camp, who believe the troubles are not yet over. And at the extreme, we have entered into a new regime for fixed income that can no longer rely on the support of central banks.

The answer stemming from this second camp is that unconstrained absolute return strategies are the way to go. Their view is that active management can deliver the necessary alpha if given sufficient flexibility across countries, duration, sector, securities and currency selection.