Rates, risk and return: What you need to know as we edge towards raised interest rates

Date: 04 Aug 2015

Bumblebee Design

Investors have grown very used to rates at close to zero but are now having to consider how their portfolio will respond if the Federal Reserve and the Bank of England change policy.

The first thing to say is that rate rises are not a done deal. Over the last few years, the market has frequently worried about tighter monetary policy in the US and UK only for economic growth to disappoint or inflation to fall, resulting in a rapid scaling back of forecasts for higher rates.

In the UK, we can still expect interest rates not to go up until early 2016 because inflation is so far below the Bank of England’s target. We also have to allow for the ongoing QE program in the Eurozone, where the ECB is buying roughly €60bn of government bonds per month. This is likely to keep a lid on bond yields in markets like France and Germany and make investments such as gilts and US Treasuries more attractive for international investors.

But what lies ahead for investment and how concerned should we be about the potential for future losses? Take, for example, bonds. Although often seen as the more predictable and defensive part of a portfolio, they are certainly not risk free. While the coupon rate is generally fixed, bond prices move inversely to yields and can therefore fall if interest rates rise and vice versa.  UK government gilts lost over 3% during the second quarter of this year and corporate bonds fared even worse.

A lot will depend on how high the market expects rates to go ultimately – at the moment, they are not expected to return to pre-crisis levels of around 4-5% because there is still too much debt in the system and a range of 2-3% would seem more likely. Even to reach that modest level is going to take time – the market is currently forecasting that UK interest rates will not return to 2% until the end of 2018 and if that is the case, bond markets will probably avoid serious losses.

There are still some grounds for concern though. One of the main issues with gilts, in theory the ‘safe and boring’ part of a portfolio, is that they can actually be quite volatile in terms of prices. A lot of bonds in a standard gilt index product are very long ‘duration’, i.e. they have a long way to go to maturity and are quite sensitive to changing interest rate expectations. There is also very little cushion at the moment in terms of income and a rise of just 1% in yields could lead to losses of roughly 8% on the gilt index – far more than a lot of cautious investors would be willing to countenance.

Of course, as ever, the best way for investors to mitigate the risk of interest rate increases is to diversify their portfolio with investments that respond differently to various economic stimuli. This will help ameliorate the effect of phenomena such as fluctuations in interest rates and help ensure that the portfolio generates good returns over time.

by Richard Carter CFA, Fixed Interest Specialist, Quilter Cheviot