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Ragtops and Higher Rates—Searching for Alpha for November 2012
One of the most often-asked questions I receive is the potential impact of higher interest rates on portfolio returns. Investors seem aware that rates are extremely low—and artificially so, give the Fed’s easy money policy—but that they may return to historic norms.
The catalyst for higher rates could have economic or market-based origins. Stronger economic growth might cause the Federal Reserve to rethink its dovish mindset and put the brakes on asset purchases, which could potentially cause higher short-term rates. Or market participants might start selling Treasury debt for the potential for higher returns in equities. Either scenario could lead to higher rates.
Advisors may want to considering adding convertible bonds if one of these scenarios unfolds. These unique fixed-income securities typically have a coupon and can be converted to stock under certain circumstances. Convertibles are sometimes referred to as “hybrid” securities, since they share characteristics of both equity and fixed-income asset classes. And the combination is unique, as it generates a return stream that has historically been unaffected by rising rates.
Why is this? First off, the conversion feature makes convertibles rise as volatility increases. And the equity-linked nature of these securities allow them to enjoy gains as rates rise, making them relatively immune to interest rate hikes. Converts should be considered as a logical portfolio addition in a rising rate environment.
About the Author
Ben Warwick, Quantitative Equity Strategies
Veteran investment strategist Ben Warwick brings 20 years of investment management expertise to AdvisorOne.com in his blog, Searching for Alpha. His market and economic insights provide readers with an insider’s view on generating alpha through asset allocation, the use of strategic portfolio “tilts” and alternative investments.
Ben Warwick founded Quantitative Equity Strategies (QES) in 2002 as a platform for implementing his quantitative investment strategies. The firm manages assets with traditional long-only equity and fixed income, private equity, managed futures and alternative investment mandates. QES has developed an industry leading expertise in building investment programs that can replicate alternative returns, while offering daily liquidity and transparency. These products include the HFRq, a hedge fund replication strategy developed in concert with Hedge Fund Research in Chicago; the Managed Futures Beta Index, with Aspen Partners; and the Nomura QES Modeled Private Equity Returns Index (PERI), which was developed with Nomura Bank and Preqin, the leading source of information in the private equity industry.
He is the author of several books, including "Searching for Alpha: The Quest for Exceptional Investment Performance," (Wiley, 2000) and "The Handbook of Managed Futures," with Carl Peters, (McGraw-Hill, 1996). He can be reached at ben@qesinvest.com.
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