Strategies to manage the risk of rising interest rates

This article was first published in Investment Week and was written for investment professionals such as financial advisers and wealth managers.

The yield on UK 10-year government bonds – often referred to as the risk-free rate of return – recently sank to below 0.5%, its lowest level on record. ¹ The milestone serves as an excellent summary of bond market conditions since the Global Financial Crisis, wherein central banks have slashed rates and bought government bonds in bulk to enhance their respective national economies. This approach has pushed gilt yields down, forcing investors to chase income in other areas - for example, corporate bonds, property or equities - all the while adding additional risk into their portfolios.

Against a backdrop of record-low interest rates, excessive risk-taking has not necessarily been an issue. Equity investors have benefitted from record market highs while property investors thrived when house prices soared. However, we believe that the tide is now changing and this sense of security could soon prove to be short-lived.

Pivotal point

Alongside global economic issues such as slowing growth and the ongoing US-China trade war, a more UK-specific matter is Brexit and, in particular, its impact on future monetary policy. With employment, real wage growth and inflation in the UK economy, we think the Bank of England (BoE) has for a time felt it prudent to increase rates, but has been waiting first for a resolution to the UK's European divorce. Entirely when this resolution, or any subsequent rate rise is delivered, it is difficult to say. However, what we do feel is that the prospect of UK interest rates rising over the next decade is far higher than that of it falling.

When this run commences, it will place considerable, additional pressure under gilt and corporate bond yields, particularly after their significant decline this year. Not only that, it will almost certainly have an impact on the equities that have been supported over the past decade through the opportunities afforded to them by cheap borrowing. All of a sudden, the levels of risk that have been lying dormant in the portfolios of investors across any risk appetite will take on a new significance.

We continue to seek out money market instruments that will allow us to continue to meet our objective of generating returns higher than cash plus fees. Given that we believe we could be entering an environment where gilts may, in fact, lose money for their holders, much of our focus is now on products that provide some immunity to interest rate risk. The assets that currently stand out for us the most are floating rate notes (FRNs), which offer several key benefits in present market conditions.

Floating rate notes

In summary, FRNs are bonds that have a variable coupon marked to a money market reference rate (in the UK, this is the sterling overnight interbank average rate, known as SONIA). Critically, FRNs are short-dated and payout coupons quarterly, with their rate re-fixing in line with their referenced benchmark in each instance. In essence, this means that if SONIA were to rise in response to a BoE rate hike, so too would the rate being paid out on a related FRN. Put another way, they provide a free hedge against rising rates.

What's more, the products we use tend to pay out an interest rate between 0.75% and 0.85% over SONIA. As at writing, SONIA sits at 0.65%, meaning our FRNs are paying out between 1.4% to 1.5% - well in excess of gilt yields. This figure becomes particularly significant when one considers the FRNs we use are fully transparent, ultra-low-cost, AAA-rated and backed by mortgages with maximum loans to value of 45%. In other words, FRNs represent the safest, most 'risk-off' way of generating a return above cash in conditions where interest rates are likely to rise. As a result, the bonds form the bedrock of the majority of our portfolios.

Seizing other opportunities

Although we allocate significant portions of our portfolios to FRNs, it is essential to remember that we are not just defending the downside. The stability of these products means we can spread allocation when excellent value opportunities arise in other asset classes paying a large ongoing coupon, yield or dividend while we wait for the realisation of that value.

On the equity side, we are finding opportunities in the banking sector, where stocks such as Aviva are hugely underpriced while continuing to pay a dividend yield of 8%. Although it is, once again, challenging to say when the stock will recover, the ongoing receipt of such a strong coupon for an asset priced considerably below its historical average is hard to ignore. That is excellent cover for a stockmarket investment, especially given that banking stocks tend to be beneficiaries of rising rates.

Likewise, we are also finding opportunities in other areas of fixed income such as the hybrid bond market. These vehicles combine debt and equity characteristics and pay a superior coupon to many other bonds. For example, hybrids from companies such as Prudential and Vodafone offer coupons in the region of 6% to 7%.

It is no doubt a time for investors to be cautious about taking a risk with their allocations. However, that does not necessarily require them to sacrifice returns completely by retreating into cash and low-yielding assets. Products such as FRNs provide returns above both cash and gilts while also mitigating interest rate risk. By using them, we achieve a steady base that we can combine with upside exposure in the form of carefully selected products that provide superior ongoing payments and the long-term chance for capital appreciation.


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