Want to Survive a Rising-Rate Environment? Avoid These Mistakes.

It’s human nature to want to protect your portfolio when the market takes a sharp turn. But too often, bond investors make the wrong choices when interest rates rise and credit cycles end. This can have disastrous consequences for returns.

US Treasury yields have shot higher lately, albeit from very low levels, as the Federal Reserve raises interest rates and shrinks its balance sheet. Some investors worry that an already strong economy may be overheating, stoking fear that the Fed may raise rates more aggressively this year and rattling global bond and equity markets.

At the same time, the US corporate credit cycle is in its late stages, while the cycle for some European assets isn’t far behind. Corporate bond valuations are at multiyear highs on both sides of the Atlantic.

It’s difficult in these circumstances to know how to position and protect your investments. Rising rates make bond investors nervous and can lead them to make decisions that may haunt their portfolios for years to come.

There are two unforced errors that investors often make at times like this. Both can come at a high cost to long-term portfolio health and total return.

Mistake No. 1: Eliminating Exposure to Interest Rates

Many bond investors react to rising interest rates the way Pavlov’s dogs responded to lab assistants when they entered the room. The dogs associated an assistant’s appearance with dinner and salivated on cue. Many bond investors have become similarly conditioned by rising rates; their knee-jerk reaction is to reduce their portfolio’s duration, or interest-rate risk.

They do this by cutting back on high-quality government bonds, mortgage-backed securities and other investment-grade debt, or by focusing on shorter-maturity securities within these sectors. These types of bonds are highly sensitive to interest-rate and yield changes, so the shorter the duration, the less damage a rise in yields will do.