Interest rate threat: how 15 wealth managers are set for a rise
Peter Elston, CIO, Seneca Investment Management, Liverpool
‘We’re positioned for interest rates staying where they are, not rising. Inflation needs propping up, not suppressing.
‘True, [Bank of England governor] Mark Carney is talking about the first rate rise getting closer, but I think he’s doing this because it’s the only tool in his armoury to hold back asset prices. His main job is goods and services price stability and employment, and in both cases we’re some way from needing a rate hike.
‘The last time interest rates were increased for the first time following a period of reductions was in November 2003. At that time, unemployment was 4.9% and core inflation above 1%. Right now, unemployment is 5.6% and it’s going to take some time to get below 5%. Same issue with inflation. ‘Carney will also be keen to avoid what happened to the US when interest rates were increased very slightly at the back of 1936 following a few years of moderate recovery: the economy contracted sharply and the stock market halved.’
James Barber, head of investments, Epoch, Bath
‘Within our fixed interest holdings we have been positioned defensively against rising interest rates for some time, a position that hindered performance in the second half of 2014, but one we remain comfortable with.
‘This defensive position has mainly been taken through strategies that employ derivatives either on top of conventional bonds to reduce duration, but maintain exposure to credit risk and some degree of interest rate risk, or through an absolute return bond strategy equally able to profit in a rising rate environment.
‘We expect to further reduce duration over the coming months, although in the UK we believe there is potential for markets to overestimate the speed interest rates will rise and we will be comfortable adding duration back into portfolios. Looking further afield, there are opportunities to utilise active currency positions and recognise opportunities within divergent monetary policy within global bond strategies.’
Kamal Haria, branch principal, Raymond James, London
‘The tightening of spare capacity in the labour market and wage growth in excess of 2.5% has created an opportunity for the Bank of England to consider raising interest rates at the earliest to help the productivity drag. The fall in oil prices is likely to have minimal impact in the second half of this year. We expect the continuation of upward inflationary trend to meet its medium term targets.
‘Any increase in interest rates is likely to create relief in the financial and insurance industries, increasing profitability and reducing risk under Solvency II. There will be few winners in the consumer discretionary and industrial sectors where value will be the buzz word. The squeeze is likely to be felt in the near term for the high end.
‘The credit spreads in the bond markets will start to widen, although we expect it to be long way off “New Norms”.
‘Expecting a bumpy ride!’
Matthew Hoggarth, senior investment analyst, Thesis Asset Management, Chichester
‘Fixed interest is the lower risk component of most clients’ portfolios, so minimising capital losses is imperative. Just dialling down the duration is insufficient however. With the yield curve so steep and tightening likely to be gradual, removing interest rate risk will reduce yield. To achieve a good level of income we have to replace the duration with other types of risk.
‘To balance our lower duration we have taken on additional credit risk via high yield bonds and mortgage-backed securities. We have introduced some equity risk through structured products and added to income-producing alternative assets such as property and infrastructure. The crux is to use a blend of strategies to diversify these substituted risks.
‘The normalisation of rates will be a drawn-out process and there may be opportunities to trade market overreactions. It is tricky to be nimble enough do this in retail portfolios that cannot hold derivatives, so we are also using strategic bond funds whose managers can be active and opportunistic to lock in returns when possible and reduce risk when necessary.’
Michelle Parkin, investment manager, Redmayne-Bentley, Leeds
‘We have seen significant fluctuations in fixed interest markets over the past three months, as global investors have speculated on when the Bank of England and the US Federal Reserve may begin to raise rates. The reality is, of course, that interest rates, as measured by government bond yields, have already started to factor in rate rises.
‘The yield on 10-year UK government debt (gilts) has risen from 1.5 per cent to nearly 2 per cent in recent months, so it is already costing the UK more to borrow in international markets. At Redmayne-Bentley, we have been looking at all of our bond funds and liaising with managers to determine the liquidity in their underlying portfolios. The big concern is, as selling supply outstrips buying demand, there will be a liquidity crunch.
‘Depending on specific client risk profiles, we see attractions in coming out of longer dated and high yield funds in favour of direct investment. Many of the debt issues listed on the London Stock Exchange retail bond market have attractive returns to maturity and are easily accessible for private client portfolios. We would focus on issues maturing around five years hence. The usual caveat applies though: ensure an acceptable spread of securities over different redemption dates.
‘Investments can fall in value and you may get back less than you originally invested. The payment of income and the return of capital could be in jeopardy in the event that the bond issuer has problems meeting its financial obligations. Please note that this article is for information only and does not constitute a recommendation to buy or sell bonds.’
Sasha Parmar, partner, Albert E Sharp, Stratford-upon-Avon
‘While the expected first rise may happen this year, I expect interest rates to remain very low for a considerable time. In recent years, economic growth forecasts have continually been revised down, wage growth is tepid and inflation pressures remain benign.
‘Furthermore, in an increasingly global market, the shock to sentiment following the Greek saga and China’s slowdown are also likely to crimp growth, making central banks reluctant to raise rates.
‘I do not expect a prolonged sell-off in bond markets and asset diversification remains prudent. Even with the recent setback, bonds have performed well over the last year and despite near universal loathing are the best portfolio diversifiers available.
‘When equities suffer a significant correction, high quality bonds provide a safe haven. The fundamental diversification attraction provides confidence in the prospect of positive long-term returns, regardless of how the bond markets behave near-term.
Nigel Chapman, senior research analyst, James Brearley & Sons, Preston
‘The first rate rise should come as no shock to markets as the increase will be well flagged in advance and will probably occur sooner rather than latter if the latest forecasts are anything to go by. That is not to say that there will inevitably be an increase in volatility on its announcement, albeit that we have already seen this in bond markets this year.
‘In advance of this turbulence we had reduced our bond exposure with absolute total return funds being a beneficiary of this reduction in our model portfolios. In a further move to mitigate possible losses we have recently invested in a Global Floating Rate Note fund in order to manage the interest rate risk.
‘We continue to prefer equities over the other major asset classes both in the UK and Overseas where we have been overweight Europe and Japan where interest rates are a long way from any increase.’
Richard Carter, fixed interest specialist, Quilter Cheviot, London
‘We’re not convinced that we’re about to experience a sharp rise in interest rates given how low inflation is, while the Fed and the MPC clearly don’t want to go down in the history books as having choked off the recovery by having raised rates prematurely. However, we do expect bond yields to drift higher over time so clearly shorter-duration funds have a key role to play in our fixed income portfolios, as well as absolute return bond funds and generally these have held up pretty well this year.
‘Our major concern about future interest rate hikes is that they could further expose the lack of liquidity in corporate bond markets so we have been diversifying our fund exposure in this field. We also retain a decent portion in short to medium-dated gilts, which might be unfashionable but they remain a valuable port in the storm.’
Kevin Bowhay, head of Bristol discretionary, Rowan Dartington, Bristol
‘Interest rates have remained artificially low following the impact of the bursting of the 2008 credit bubble and the use of quantitative easing in many countries.
‘Countries, probably led by America, will need to normalise their rates at some point but there remains no certainty about the timing or extent of the first interest rate rise. The recent Greek negotiations and Chinese slowdown are putting pressure on the current world economic recovery and with the absence of inflation we think it is possible that rate rises are pushed further out into 2016 notwithstanding Carney’s recent comments and Yellen’s testimony.
’ We remain underweight Bonds notwithstanding the need to maintain the balance of risk for those clients who seek more security within their portfolio. In particular we are negative on Gilts where the average duration is 12 years. Although the outlook for High Yield, Indexed Linked and Global Bonds is weak in an environment where interest rates are rising they do provide both income and diversification in portfolios. We remain invested into Investment Grade Bonds but only where we can invest strategically or within low duration funds. Our underweight to bonds has led to a higher investment in Infrastructure, property and absolute funds. We recently made a significant investment in Kames Capital Property.
‘With regard to direct equities we have a zero weighting in Utilities (often seen as a proxy for bonds) overweight banks and have a full weighting in house builders following the election of the Conservative Government although we remain wary of the potential interest rate impact on this sector.’
James Spence, managing partner, Cerno Capital, London
‘We expect the Fed to hike in September in response to the general firming of the US economic picture, with employment data being preeminent to their assessment. The Bank of England will not be far behind them. However, we tend to agree with Governor’s Yellen predication of a shallow path to future increases as we think economic growth will tend to disappoint and inflation will remain abeyant.
‘Irrespective of the immediate reaction in markets from this hike, we doubt whether this will create a meaningful steepening of the yield curve nor dislodge equities as the asset class with the best return profile. The risk to this assessment is that either growth or inflation surprise on the upside, creating severe headwinds to financial assets which are highly valued. Higher US rates provide impetus to dollar strength which presents clear threats to the Emerging Markets complex. Consequently, we remain very underweight EM assets.’
Bryan Innes, executive partner, Towry, Aberdeen
‘Markets had been expecting the first rise in UK interest rates to come in around mid 2016. However there was little real reason to think it should be so far behind US expectations, and indeed Mark Carney is now suggesting around that the turn of the year is quite possible. However, this will create even more of a bid for sterling, which arguably is anyway doing much of the tightening for the Monetary Policy Committee.
‘The UK economy remains badly unbalanced, and choosing to opt out of the "currency wars" is not helping matters. As investors we need to be concerned about the duration of our bond holdings, although we took the appropriate defensive action on this quite some time ago.
‘It is uncertain what impact a rise in UK rates will have on markets and the economy, but given the UK's reliance on house prices and debt, it is unlikely to take many rate rises before a negative impact is felt, and so, on the contrary, if bond yields back up a bit further then it may actually be prudent to add some duration back in to portfolios.’
Jonathan Horsfield, associate director of investments, Cornelian Asset Managers, Edinburgh
‘While much of the discussion around the impact of rising rates has focused on bond markets, the risks posed by an increase in the cost of money apply to virtually all asset classes, and we have taken broad based action to position client portfolios accordingly. In fixed income we are invested directly in only very short duration government bonds with minimal sensitivity to rates and favour unconstrained credit funds, where managers are not tied to a benchmark and can use derivatives to actively hedge interest rate risk.
‘Additionally, we hold a range of assets that will be immediate beneficiaries of interest rate rises, such as shares in banks and insurance companies within our direct UK equity positions, and floating rate securities within our credit exposure. While we remain constructive on equities overall, valuations and earnings have clearly been boosted by cheap money. It seems rational to us that the unwinding of this support could cause a correction in equity prices at some stage and we have reduced exposure accordingly.
‘We have also increased allocations to cash and absolute return strategies. The ability for macro hedge funds, for example, to profit from rates and currency trading is likely to be greatly enhanced by increased monetary policy action, while equity long/short funds look well-placed to profit from future equity market volatility.’
John Thornber, investment manager, Andrews Gwynne Private Wealth Management, Leeds
‘The spectre of rising interest rates fills the headlines but in our view is a minor worry in view of the bigger picture.
‘Simply put the rate rises being talked about in the US and UK are so small and well telegraphed that if you think your portfolio valuations make no sense if rates rise slowly to 1% we would suggest they make no sense now.
‘Secondly despite the current noise both the BoE and the Fed have actually been anticipating rate rises “next year” for five years (and we still listen?) and it hasn’t happened because of the weak economic background with even fragile recovery figures dependent on ever more debt.
‘In our view the problems that brought us to crisis in 07/08 may have morphed but in many ways the imbalances are now worse and we believe (like the BIS and IMF) that the main reason Central Banks need to raise rates is to store dry powder for the next crisis, meaning rates rising a lot more than 0.5%. Frankly we think they will be lucky to get the opportunity.
Matthew Stanesby, investment director, Close Brothers Asset Management, London
‘Although we expect rate rises to be slow and incremental, any rise, or even the perceived threat, may result in a capital loss on fixed income investments. With yields on government bonds so low, we have a preference for corporate credit with higher yields, which may provide a cushion to potential capital loss.
‘We prefer short duration credit and have also added floating rate exposures as well as strategic bond funds, which can manage interest rate sensitivity and isolate value in individual credit spreads. In terms of equity exposure, there may be a knock-on effect to the “bond-like” equities which have become expensive in the hunt for yield.
‘We have been reducing this exposure in favour of cyclicals. Lastly, we have invested in financials as they tend to do better in strengthening economies, due to non-performing loans falling and interest rates working in their favour.’
Ben Kumar, investment manager, 7 Investment Management, London
‘The finance world is built on disagreements, which is how you end up with one person willing to sell a bond whilst another is willing to buy one. There is one view that is pretty much unanimous at the moment though, and that is that the future path of interest rates is upwards. The argument comes when discussing the time period.
‘In the UK, 7IM have been positioned for rising interest rates for over two years. Back in 2013, we cut the majority of our Gilt and Global Bond positions, and significantly reduced the duration (ie. interest rate sensitivity) on the remaining holdings.
‘More recently, we have been looking for fixed income products that are less exposed to the rate cycle of the US and UK. This has meant purchases of Asian fixed income, where monetary policy has scope to get looser still, and yields provide a decent rate of return.’