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BOURBON FINANCIAL MANAGEMENT
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Patrick Bourbon

Patrick Bourbon, CFA

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Table of Contents
 
 
 

The BFM Board

  
Ivan Leveille Nizerolle, CFA, FRM
 
 

Ivan has close to thirty years of experience. He began his career with Banque du Bâtiment et des Travaux Publics in the treasury Department. In 1989, he moved to the Crédit Agricole Group as a derivatives products and interest rate trader on the French and German markets. He moved to Chicago in 1999 and was an analyst focusing on the arbitrage and multi-strategy managers based in North America, before becoming a Senior Portfolio Manager, Managing Director of Credit Agricole Asset Management Alternative Investments (CAAM AI), which had $15 billion under management.
He is an expert in asset allocation and mutual funds due diligence.

Ivan has the French equivalent of a Masters from the University Paris-Dauphine in Financial Markets and Business Management. He also has a Master's degree in Economics from the University of Paris-Sorbonne and a Masters in Engineering from the Ecole Nationale des Travaux Publics (ESTP).

 

 

Caroline Attia



Former member of the French ski team (9 years), Caroline won a world cup race in downhill and participated in two Olympic Games. She was a trader for 25 years at Crédit Agricole and Société Générale specializing on interest rates and electronic trading. Her “high risk” experience in ski and trading, taught her that decision making process, emotions, psychology, and ethics, are the keys to success... or failure. She is the author of a book dedicated to psychology, and financial decision making “Financiers sur le divan”. Today, Caroline is a therapist and a business consultant. 
 
Caroline holds three degrees in Economics, Marketing, and Psychology from Paris-Dauphine, Assas, and Toulouse Universities, and an MBA from HEC.




Gilles de Barbeyrac
 
 
 
Gilles has spent his whole career in credit risk and market risk functions. Gilles worked in the Risk Management department of Calyon Financial (a derivatives brokerage firm that merged with Fimat in 2008 to form Newedge) from 1999 to 2008. He became its Counterparty Risk Manager in 2006.
Gilles is now the Credit Risk Manager of RBC Investor Services BankFrance, a depositary bank which is part of the Royal Bank of Canada group.

Gilles also successfully passed the CFA exam in 2004 (Level 3). He holds a bachelor’s degree in finance from University Paris Dauphine and an MBA in finance from Loyola University Chicago.


 
 
Laurent Barocas
 
 
 
Laurent brings more than fifteen years of experience in financial markets serving both Buy-side and Sell-side global institutions. Most recently Laurent joined Bloomberg’s Portfolio Risk & Analytics product team to focus on the development and commercialization of Bloomberg’s portfolio capabilities. Laurent started his career in Chicago as an Interest Rates Specialist for ABN AMRO fixed income investment portfolio. Then he moved to London in senior portfolio specialist roles within investment banking research departments at Citi and Lehman Brothers. Laurent transitioned in 2008 as a Director to Barclays Capital Index, Portfolio & Risk solutions team.

Laurent holds an Masters in Computer Sciences from Paris-Dauphine University and an MBA in Finance from the University of Chicago, Booth School of Business.



 
Juan Carlos Espina
 
 
 
Juan joined the Federal Home Loan Bank of Chicago in 2004, and has played many different roles with increased responsibilities within risk management. Currently he works as a Vice President of Credit Analysis for unsecured credit covering Federal Fund, Reverse Repo and Derivatives counterparties.
Before, he worked in risk management at Bank One (JP Morgan), and has corporate banking experience in Latin America (Banco del Caribe – Scotiabank). Juan also has commodity trading exposure (Chicago Board of Trade).

He graduated with a Bachelor of Science in Engineering and Agronomics (Universidad Central de Venezuela, 1996), and a Master of Science in Finance (Illinois Institute of Technology, 2000).

 

 
Fabienne Legger
 
 
 
Fabienne brings over 15 years of senior international expertise in the area of strategy, operations, business infrastructure/transformation, compliance and international business expansion. She started her career within Euronext Group (formerly SBF – Bourse de Paris) where she led a number of leadership and consultancy roles in Europe, U.S. and APAC, including 2 years in Chicago, where she was part of the team which worked on the technology swap between Euronext and the CME (trading/clearing). Then she moved to Switzerland and expanded her know-how to the brokerage, banking and insurance sectors. She worked for key global players such as Interactive Brokers, Credit Suisse, E*TRADE and SwissRe, and held senior management positions as Head of Regional Business and/or Operations.

Fabienne holds a Master's degree in Business Administration and Management. She is passionate about “making business work” in profitable, sustainable, and socially responsible ways. She considers Operations as a key strategic competitive business asset.


 
 
Pierre Monperrus
 
 
 
Pierre is a Director with over 13 years of Management Consulting experience at PwC. Pierre specializes in financial effectiveness and process improvement initiatives. He has significant experience transforming finance functions to assist corporate and private equity clients quickly integrate acquired companies.
Finally, Pierre also has expertise in audit approach & risk management.

He holds a Masters in Corporate Law and a Masters in Business Management. He is currently a part time student (executive program) at the Kellogg School of Management at Northwestern University.


 
 
Sagar Sheth
 
 
 
Sagar is currently Managing Director and Head of Chicago for MKM Partners. Sagar previously served as a Director in the Global Markets Group at Deutsche Bank where he was a top ranked Institutional Equity Salesperson. Prior to Deutsche Bank, Sagar spent nearly four years at UBS Investment Bank in the Equities Group. He also held positions as an Associate Quantitative Analyst at UBS Global Asset Management and as a Business Analyst at Morgan Stanley’s Discover Financial Services Group. He has a broad background in business development and has built a vast network of executives that stretches across the globe.

In his personal time, Sagar is an Adjunct Professor at the IIT Stuart School of Business in Chicago teaching a course on Investment Banking, Global Markets and Hedge Funds. Sagar also gives back to the community as a member of the Board of Directors of the Israel Idonije Foundation, and is an active supporter of the Cystic Fibrosis Foundation, the Foundation for Educating Children with Autism, as well as a variety of other nonprofits.

Sagar received an MBA from the University of Chicago Booth School of Business, and he graduated from University of Michigan with a Bachelors in Economics. He is also a licensed Illinois Real Estate Managing Broker and holds multiple securities licenses.
 
 
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Executive Summary
 
In this newsletter, we discuss interest rates and address the concerns of investors arising from historical low interest rates, the Fed’s ending of Quantitative Easing, and an environment of potentially rising interest rates later this year.

An important point to make is that rising interest rates do not necessarily have a negative impact for bond investors as often perceived. For one thing, an increase in interest rates is accompanied by higher interest payments over time. Even though the price of a bond fund may drop in value over the short-term, higher yields/rates could eventually help bond fund investors. While bonds are not as attractive as before, they have historically provided downside protection to portfolios. Bonds help you sleep better at night.





Another important concept is understanding how interest rates affect different asset classes (stocks, bonds...) differently and therefore, in order to hedge against rising interest rates, having a diversified portfolio becomes very important. Investing in other asset classes can help an investor mitigate the impact of an increase in interest rates on bond funds.
 
In order to reduce a portfolio’s sensitivity to interest rates, we recommend diversifying your fixed-income investments with shorter duration and global bond strategies.

 
Introduction
 
How would your bond fund perform if interest rates would go up by 1%? You would need to look at your fund’s duration (interest rate sensitivity) and yield. If your fund has a 4-year duration, your fund may suffer a 4% drop but the fund’s yield will offset portion of that drop.
 
Interest rates are one of the most important factors in determining a portfolio’s performance over time. It affects almost every asset class and has the potential to considerably affect an investor’s returns. Therefore, it is very important to take interest rate factor into account before making any investment decision. Sudden and drastic changes in interest rates can significantly impact your portfolio. Since the 2008 financial crisis, the U.S. Federal Reserve (Fed) has been playing a major role in driving the economy out of its troubles by injecting money in the economy (also known as Quantitative Easing) and by keeping the interest rates very low. One benefit is that we can borrow at very low rates. This allowed the investors to worry less about rising interest rates but we believe that will be changing in the next twelve months. With the Fed’s announcement in October 2014 of officially ending the Quantitative Easing period, as it believes the U.S. economy is back on track, investors have again become concerned about interest rates. Investors expect the Fed to raise interest rates in late 2015.

 
1. History of Interest Rates

To understand how interest rates play out in changing economic environments, we present the following chart.
 
10-Year Treasury Yields Since 1871


Source: Bourbon Financial Management, www.multpl.com; Data as of 12/31/2013 
 
Over the past 30 years, investors have grown accustomed to receiving capital appreciation in addition to income from their fixed-income allocations.


Since 1994, there have been three periods of increasing federal funds rates. However, each of these periods has had unique factors that impacted the way fixed-income investments/investors responded.
 
 
Market Conditions during Periods of Increasing Fed Funds Rates



Sources: Bloomberg, www.federalreserve.gov, Barclays Live. Data shown applies to the actual time periods noted in the table.
Notes:1. Represented by the 10-Year Treasury yield  2.  Yield difference between Barclays Corporate U.S. Investment Grade Bond Index and Barclays U.S Treasury Index. Change in Credit Spread Levels is measured from the beginning to the end of each period. 3. Yield difference between 2-year and 30-year U.S. Treasury securities measured at the beginning of each period.


Fixed Income Sector / Asset Class Performance
During the Three Most Recent Interest Rate Environments



Source: T. Rowe Price; Data represents the Citigroup 3-Month Treasury Bill, Barclays 1-3 Year Government/Credit Index, Barclays US Aggregate Index, Barclays US Mortgage-Backed Index, Barclays US Credit Index, CS High Yield Index, Barclays US TIPS Index (incepted 1997), and the Barclays Treasury Long Index




2. Factors Influencing U.S. Interest Rates


Inflation May Push Interest Rates Higher


A lender may be reluctant to lend money for any period of time if the purchasing power of that money will be less when it’s repaid; the lender will, therefore, demand a higher rate. Thus, inflation may push interest rates higher.

Interest Rates vs Inflation Rates 


Source: Bourbon Financial Management, www.multpl.com, U.S. Inflation Calculator


Economic Conditions Affect Interest Rates

As we can see in the chart below, economic conditions impact interest rates. There seems to be positive correlation between economic performance and interest rate levels. This makes sense as improving economy puts consumers at ease and the general spending level increases, which translates into more borrowing from banks and other lenders. Thus, higher demand for funds results in increasing interest rates. 

Interest Rate vs GDP Growth 

Source: FRED

 




3. The Impact of Rising Interest Rates

Relative Impact of Rising Interest Rates on Price of Fixed Income Securities


Other factors being equal, the fixed income investments in the “high impact” bucket are likely to experience the greatest price declines as interest rates rise, while the investments in the “low impact” bucket are likely to experience the smallest price declines as interest rates rise. In addition, factors other than interest rate changes—such as credit quality, leverage, call features and general economic conditions—may also affect the prices of particular fixed income instruments.


Source: UBS. As of 2013


Bond Prices and Interest Rates Have an Inverse Relationship
 
 Bond prices generally rise (fall) as interest rates fall (rise), as demonstrated by the historic 5-Year U.S. Treasuries’ yield and price return.
 

Source: FactSet, Bank of America Merrill Lynch. Data as of September 30, 2014.

 

Are Rising Interest Rates Always Bad for Bond Investors?

It is a common perception that rising interest rates only bring bad news for bond investors. But we will try to show it’s not always the case.

In order to understand how much interest rates can actually impact our portfolio, we need to start with understanding the concept of duration.


 
The Longer a Bond’s Duration, the Greater Its Sensitivity to Interest Rate Changes, All Else Equal

Duration may seem like a complex calculation, but it is important to know the duration of your portfolio and try to keep it at an optimal level to hedge your investments against any drastic change in interest rates.
Interest rate duration measures the responsiveness of a bond’s price to interest rate changes. The values presented are approximate effects given sample durations across six scenarios of interest rate increases, assuming parallel shifts in yield curve.



Source: Bank of America Merrill Lynch, 2014. Note: Duration is a measure of a bond or bond portfolio’s price sensitivity to interest rate changes. Yield to Worst (YTW) is generally defined as being the lowest yield that a buyer can expect to receive. Figures are based on BofA Merrill Lynch Current 5-Year US Treasury Index.


Interest Payments Have Actually Helped Offset Negative Price Returns over Time
Coupon Returns Have Been Positive and Helped Offset Negative Price Returns


Rising interest rates often translate into higher interest payments over time. So, although the price of a bond fund may drop in the immediate term due to rising rates, over time, higher rates could eventually help bond fund investors.



Source: Barclays U.S. Aggregate Bond Index, as of 12/31/2013. Pay down returns, which are a component of the total returns, are not shown as a separate column. Note: In the past 15 years, price returns have been negative seven times, and in all but two of those years, the interest return helped to fully offset the negative price return


Income Has Dominated Return

Approximately 93% of total return has been generated by income rather than price movements. This is true for both high grade and high yield bonds. Income dominated total return even in the wake of the credit crisis, when high yield experienced a significant price rebound.



Source: Barclays. Data as of 3/31/14. Chart shows the percent of annualized total return derived from coupon return (as opposed to price appreciation). The Barclays Aggregate Bond Index has an inception date of 1/1/76. The Barclays U.S. High Yield 2% Issuer Capped Index has an inception date of 1/1/93. The index returns presented are for illustration purposes only and do not represent or predict performance of any Nuveen Asset Management product. Indices are unmanaged and unavailable for direct investment. Past performance is no guarantee of future results.

 

Income Drives Bond Fund Returns over Time

It may come as a surprise that the returns from a "passive" portfolio of fixed income investments has come almost exclusively from returns on interest payments from individual bonds, reinvested and compounded over time. Furthermore, more than 90% of the total return since 1976 generated from a broadly diversified portfolio of U.S. investment-grade bonds has come from interest payments, not change in price.



Source: Barclays. Returns shown are from monthly Barclays U.S. Aggregate Bond Index returns from January 1976 to December 2013. Total return equals income plus change in price with a reinvestment of interest payments.




4. The Strategies to Hedge Against Rising Interest Rates


Asset Class Performance during Rising Interest Rate Periods
 

One of the most effective strategies to hedge against interest rate risk is to diversify your portfolio by investing in different asset classes. As we mentioned before, interest rates affect different asset classes differently and therefore, diversification helps counter the change in one asset’s performance against other.
In the following few graphics, we show how rising interest rates period affected the different asset classes.


Rising Interest Rate Period 1: 2/1/94 – 2/28/95

 
Rising Interest Rate Period 2: 6/1/99 – 5/31/00


Rising Interest Rate Period 3: 6/1/04 – 6/30/06

Sources: Morningstar
Note: 1 Represented by Barclays Capital Mortgage-Backed Securities Index due to limited track record of the Barclays Securitized Debt Index. 



In rising interest rate period 2, high yield corporates and preferred securities both experienced negative returns due to the volatile equity markets. Global bonds also experienced negative returns due to the impact of currency. When U.S. rates rise, the dollar tends to appreciate as higher rates are a positive factor for currency returns. However, short-term corporates had a good performance in this rising rate period. In rising interest rate period 3, all fixed income asset class experienced positive returns. Rates rose gradually over a long time period, with the Fed rising rates 17 times in small increments over a 24-month period. 


The Performance of Equity and Bond around Fed Tightening Cycles, 1950 - 2010


Source: Fidelity Investment (AART), data as of 9/30/2014. Note: Fed: Federal Reserve. Fidelity Investment proprietary analysis of historical asset class total returns, using data from indices from: Barclays, Fidelity Investment, Morningstar, Standard & Poor’s.


Fed tightening cycles means that the Fed will "make money tight" by rising short-term interest rates. Historically, U.S. stocks have posted solid returns prior to and immediately following the Fed’s first hike of a tightening cycle, with double-digit average returns one year ahead of and one year after the first rate increase. Bond performance has tended to slow prior to and just after the first hike, though returns have generally been solid two years later.


Finding Higher Yields with Less Interest Rate Risk

Low correlations to traditional core bonds make high yield and floating rate loans compelling strategic allocations and powerful fixed income portfolio diversifiers.

Yield to Maturity vs. Interest Rate Risk (Represented by Duration)


Sources: Barclays; Bloomberg; JPMorgan; S&P/LSTA, as of 12/31/13.
 
 
Outperformance of Bank Loans in Weak Treasury Markets

Bank Loans, or “Floating Rate Loans,” Have a Low Correlation to Treasury Prices and May Serve as an Effective Diversification Tool



Sources: Credit Suisse Institutional Leveraged Loan Index (represents senior-secured, U.S.-dollar-denominated non-investment grade loans), and the BofA Merrill Lynch U.S. 10-Year Treasury Index (measures the total return performance of U.S. Treasury bonds with a maturity greater than 10 years). The chart above shows every quarter since 1992 where 10-Year Treasury performance was negative, and the performance of the Loan Index in those same quarters.


High-Yield Credit Has Been a Historically Strong Performer during Periods of Rising Interest Rates

Credit sectors—particularly high-yield bonds—have historically fared well in most periods of rising rates. Credit performance is linked to corporate fundamentals, which tend to improve when rates rise, offsetting some of the price decline. Income is also potentially available in many other sectors of the credit market beyond high-yield corporate bonds.

U.S. High-Yield Performance in Rising-Rate Environments 1994–2013



Source: Barclays, Bloomberg and Alliance Bernstein, as of December 31, 2013 US high yield by Barclays US High Yield 2% Issuer Capped. An investor cannot invest directly in an index and its performance does not reflect the performance of any Alliance Bernstein portfolio. The unmanaged index does not reflect fees and expenses associated with the active management of a portfolio.
 



Ultra-Short Bonds, Floating-Rate Loans and High-Yield Bonds Outperformed When Interest Rates Have Risen by 1% or More

Compared to other fixed-income asset classes, floating-rate loans are typically less vulnerable to and are more sensitive to credit and default risks. Floating-rate loans are debt instruments with a variable rate that generally resets every 30 to 90 days. Because of their shorter maturities, short-term bonds are typically less vulnerable to rising interest rates than longer-term bonds. Short-term bonds offer a shorter length of time (about one to three years) until principal must be repaid. Short-term bonds typically have the least fluctuation of principal, followed by floating-rate loans and finally by intermediate-term bonds and long-term bonds, which typically have the most. Corporate bonds are subject to taxation; municipal bonds are generally free from federal income tax.

(Annualized Total Returns, 2/92–6/13)

Source: Morningstar as of 6/30/13


The Performance of Asset Class When Interest Rates Remain Unchanged and Increase over the 12-month Period 

Three different hypothetical rate scenarios show how various taxable fixed income asset classes would perform over a 12-month investment horizon – first with no change in rates, and then with 50- and 100-basis-point (1%) parallel shifts along the yield curve. Each asset class is broken into short and long duration buckets. For example, the one-to-five year Treasury bucket is a sample portfolio of Treasury bonds maturing between 10 and 30 years.
In the case of both interest rate increases, shorter duration then outperforms longer duration across the board; if interest rates remain unchanged over the 12-month period, long duration outperforms short duration in every asset class.

12-month total return for a given parallel shift in the yield curve


Note: A basis point is a unit of measure that describes the percentage change in a financial instrument. One basis point equals 0.01% of a percentage point. Source: the yield Book, Morgan Stanley Wealth Management as of June 14, 2013.


Short Duration Strategies 

In anticipation of rising rates, investors can prepare themselves by reinvesting in shorter-maturity securities.

Longer-maturity securities can underperform when interest rates rise


Source: Wells Fargo Advisors

 
Bond Strategies 

Bond investing requires assessing and balancing risk exposures, not return potentials. The 30-year decrease in interest rate (nice tailwind) will no longer be at your back. Return expectations need to be revised downward.

The Relationship between Yield and Standard Deviation (a Measure of the Volatility of Returns)
 
The Yield/Volatility Relationship


Source: Barclays; Bloomberg. Current yield measured as the yield to worst as of 4/30/13. Standard deviation calculated for the 10-year period ending 4/30/13. As of April 30, the Barclays U.S. Aggregate Bond Index has a current yield of 1.7% with a 3.3% standard deviation of returns. If someone wanted to achieve the 10-year historical average yield of 4% in this low yield environment they would have to consider Emerging Market Debt (4.1% yield), which carries three times the volatility.

 
Globally Oriented Strategies

Bond markets of different countries travel varied paths. A global strategy may reduce direct exposure to U.S. rates. Currency-hedged global bonds have historically captured greater upside when U.S. rates rise and less of the downside when rates fall. Currency volatility can be an unintended consequence of unhedged global bond exposure; hedged global bonds have delivered similar returns with less risk in the past
 
Global bonds can offer global diversification through non-US-dollar yield curves and currencies. Global diversification across countries, currencies and credit sectors can enable investors to potentially reduce risks during downturns in particular markets and to take advantage of differing business cycles and economic conditions around the world.



Bond that Invest in Many Countries May Help Reduce a Portfolio’s Sensitivity to Rising U.S. Interest Rates
 
Returns and UP/Down Capture Ratios (March 1990 – December 2013)


Source: Barclays and Alliance Bernstein. Data as of December 31, 2013
Note: Returns represented by Barclays US Aggregate Bond Index and Barclays Global Aggregate Bond Index Hedged to USD。An investor cannot invest directly in an index and its performance does not reflect the performance of any Alliance Bernstein portfolio. The unmanaged index does not reflect fees and expenses associated with the active management of a portfolio.


 
Relatively Higher Short -Term Yields Available Outside the United States

One important factor to consider when investing in global strategies is how currency risk is managed in a bond portfolio. Currencies can be volatile in their own right and will impact the total return of bond investments denominated in local currencies. At times, currency returns can even overwhelm bond returns.

Two-Year Government Bond Yields, As of June 30, 2014

Source: Bloomberg, LP. Data as of 6/30/2014.

 
Investors Should Consider Individual Circumstances, Risk Tolerance and Investment Goals
When Making an Investment Decision.


These charts show sample fixed-income portfolios that offer a potential starting point for investors concerned about rising rates. Investors should consider individual circumstances, risk tolerance and investment goals when making an investment decision.







Source: Nuveen Asset Management, LLC. Data as of May, 2014.
Note: Sample Portfolios, Risk/Return, Portfolio Characteristics and Performance charts show hypothetical strategies.



 
Conclusion
 
We recommend effective strategies to lower potential interest risks: diversify your fixed-income investments, shorter duration bond strategies, and globally oriented strategies.
With these strategies in place, investors can be more confident of protecting their portfolios against any raise in interest rates. We also believe that rising interest rates will not necessarily have a negative impact on bond funds. Therefore, we still recommend diversified portfolios that include fixed income investments to offset the volatility of the stock portion of the portfolios.
 

 


 

Appendix - Past Newsletters






 








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This newsletter is not investment advice or trade recommendations. Many factors beyond those discussed in this newsletter exist in determining a proper investment allocation and whether global investing is appropriate for each individual investor. We welcome all questions and comments regarding investing and retirement concerns.