Is Your Investment Portfolio Prepared for Higher Rates?

By Steve Twersky

Given the expectations for higher rates as the Federal Reserve tightens, that’s a question you’ve likely thought about. But a better question may be: “Is your portfolio prepared for the coming shift in the yield curve?” Market rates along the curve rarely move in a parallel fashion, and the change in the slope of the curve can be just as important as the actual change in rates.

History has shown us the curve typically flattens sharply as the Fed raises short rates. The nearby table shows the change in the 10-year Treasury yield between the first and last Fed move for the last two tightening periods.

twersky-graph

Note the very modest change in longer yields. It’s also noteworthy that in both instances, the funds target rate exceeded the yield of the 10-year by the time the Fed made its last move—resulting in inverted curves.
There is every reason to believe the current tightening will play out in a similar fashion. Without broad, sustained economic growth, there is little to pressure longer term rates to move much higher. Indeed, if the Fed raises the short end too fast or too much, it risks laying a foundation for the next recession and thus pushing longer rates lower.

So what’s the best strategy to address this coming flattening? From a pure total return or economic value standpoint, some variation of a barbell approach would be optimal. Shorter cash flows are important to be able to reinvest at higher rates as the short end of the curve pushes higher. But longer bonds also do very well, as the current steepness allows for the capture of needed higher yields with limited projected losses as the curve flattens.

But bank portfolio managers have to consider much more than simply the best place to be on the curve. The repricing and liquidity needs of the entire balance sheet must also be considered. And those seeing increases in loan demand need to make certain liquidity is readily available for funding.

We would take a balanced approach right now:

  • Make certain the portfolio maintains a good degree of roll-off over the next five years, even as rates rise.
  • To provide balance to this short focus, target some degree of call-protected, longer-term bonds. The higher level of absolute yields in longer bonds is needed to keep margins from declining as deposit rates begin to push higher. These longer bonds will also help you maintain a higher overall yield should the Fed moves shut down enough economic growth to cause longer-term yields to fall. The tax-exempt municipal market provides one of the best sectors for banks to accomplish this, given the steep slope of the curve as well as the extended call protection available.

With the strong likelihood that the Fed will continue to ratchet short rates higher for the near term, it’s hard to fight the temptation to keep funds very short to invest later at higher yields. We think a more balanced approach is needed—one that targets some degree of longer bonds to allow you to optimize yields now, benefit from continued flattening in the curve and protect against an economic downturn.

Steve Twersky is EVP and manager of the portfolio strategies group at FTN Financial, Memphis, Tenn.