As rising inflation continues to grip markets, investors are looking for ways to protect their portfolios against the potentially damaging effects.
Whether inflation this time around is a short-term issue or something we all need to get used for the foreseeable future, its effect on cumulative returns can be long lasting if or when interest rates continue to rise in line with inflation.
Multi-asset investors, some with cash plus targets, face a dilemma in this scenario - how to beat inflation yet remain true to their investment process.
Do they simply move further up the risk scale increasing the potential of heavy losses if markets go against them? Do they buy ‘expensive defensives’, and at what cost? Do they move to cash or worse, negative-yielding bonds? What about derivatives – can asset managers justify and explain that position to investors who want to understand exactly where and how their cash is invested?
It could be that the investment instruments and tactics that portfolio managers employ to navigate through the potentially rough seas ahead will make all the difference.
No frills to avoid thrills and spills
Take, for example, the humble Floating Rate Note (FRN). “What on earth is a Floating Rate Note?” I hear you ask.
FRNs are debt instruments, typically issued by financial institutions, supranationals (e.g. the European Investment Bank) and governments, and, as the name implies, FRNs differ from other fixed income securities by having a variable (floating) coupon rate.
The coupon on a FRN is re-set every quarter to a specified level over the reference rate such as SONIA (Sterling Overnight Interest Average). When interest rates rise, SONIA, in turn, ratchets up and consequently, the coupons on FRNs increase.
Simply put, as interest rates rise, so does the coupon on FRNs.
They are therefore negatively correlated to, or provide a hedge against, a rise in interest rates, and unlike derivative hedging and structured products, the FRN hedge costs little.
Gilts and other debt instruments, such as investment grade and high yield corporate bonds are positively correlated to interest rate movements so will fall in value when interest rates rise.
For this reason, FRNs make up a significant component of the investment grade bond market and tend to be in high demand when interest rates are expected to increase.
For Absolute Return strategies, aiming for positive returns in excess of cash, FRNs provide a useful hedge against rising interest rates and help moderate volatility. They are also fully liquid so when volatility increases in other asset classes, creating mispricing, fund managers are able to sell FRNs to exploit those opportunities.
After decades of falling interest rates in the UK, the direction of travel might have changed, and rates have started to rise. James Mahon and Jerry Wharton, co-managers of our own Church House Tenax Absolute Return Strategies Fund are clearly placing a lot of faith in FRNs with a 38.3% allocation.
If rates now rise faster and further than most investors and commentators expect, gilts and corporate bonds will become more volatile - FRNs on the other hand will, much like the tortoise in Aesop’s fable, quietly and surreptitiously win the race against the inflation hare.