Interest Rate Risk Not Specific To Rising Rates

Written by: Shiv Patel | Advisor Asset Management

When income investors are concerned about interest rate risk, most tend to associate it with rising interest rates. And while higher interest rates across the economy can indeed pose a substantial risk to portfolios — particularly for those investments with cash flows more distant into the future — the volatility of interest rates should be of equal concern. Whether interest rates are following a broader increasing, flattening, or declining trend, their volatilities in between can still be detrimental to portfolios exposed to higher levels of interest rate risk.

We can see this impact play out when comparing broad, fixed-rate, and variable rate preferred securities across various interest rate trends. Over the last 10 years, variable-rate preferreds averaged an effective duration of around 3.5 years compared to about 4.8 years for broad preferrreds, and 5.4 years for fixed-rate preferreds. Over the same time, the U.S. 10-year Treasury rate — which has risen to 4.1% from 2.8% — saw an annualized volatility of over 50%. As such, the relatively lower duration variable-rate preferreds saw the lowest volatility across the three preferred categories.

U.S. 10-year Treasury rate


Source: ICE Data Services, 5/30/2013 – 8/30/2023 | Past performance is not indicative of future results.

Specifically focusing in on a rising interest rate period, we indeed see the duration impacts become more pronounced. As the U.S. 10-year Treasury rate nearly tripled to 4.1% from 1.4% over the almost two-year period, the higher duration fixed-rate preferreds experienced meaningfully higher volatility compared to broad and variable-rate preferreds.

U.S. 10-year Treasury rate


Source: ICE Data Services, 11/30/2021 – 8/30/2023 | Past performance is not indicative of future results.

However, when focusing in on a relatively flat trend of interest rates, we can still see the dynamics hold. Over the approximately 3.5-year period, the U.S. 10-year treasury rate ended at 2.41%, right near its starting rate of 2.48%. Despite even moving slightly lower, elevated interest rate volatility still translated to higher portfolio volatility for higher duration preferreds. With an annualized volatility of nearly 35%, the 10-year rate did not have to rise in order for interest rate risk to generate unfavorable portfolio outcomes. Moreover, although fixed-rate preferreds saw stronger performance in the flat to declining interest rate environment, on risk-adjusted basis it still lagged relative to its variable-rate counterpart.

U.S. 10-year Treasury rate


Source: ICE Data Services, 5/31/2014 – 12/31/2017 | Past performance is not indicative of future results. *The Sharpe ratio compares the return of an investment with its risk. It's a mathematical expression of the insight that excess returns over a period of time may signify more volatility and risk, rather than investing skill.

As interest rates remaining higher for longer continues to be reinforced as the likely path forward, it has not stopped investors to waver between the rising and falling interest rate narrative. Through expectations of potential flattening or falling interest rates, many income seeking investors are enticed to extend duration in search of relatively higher yields. However, it is important to remember that rising interest rates are not the only source of interest rate risk. Interest rate volatility can pose an equal risk to the preservation of portfolio value irrespective of the broader directional trend of interest rates.

Additionally, maintaining a diversified coupon structure of securities within a portfolio has the potential to be helpful. As we move through various interest rate environments, a blend of coupon structures can position investors to have the potential to be able to participate in higher yields and returns when they emerge while also potentially mitigating the impacts of interest rate volatility along the way.

Related: Risk Tolerance: The Types + Why It Matters