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Navigating through rising interest rates.
By Eugene Stanley
A combination of certain ongoing events will undoubtedly continue to be disconcerting for investors, namely the successive rate hikes by the Federal Reserve (FED) and global geopolitical tensions. In fact, US Treasury yields have been steadily rising as the U.S. economy continues to record strong growth (2.9% in 4Q17 and 2.3% in 1Q18). The Fed has clearly stated its intention to raise rates at least 3 times in 2018 and many analysts have priced in 4. Since the start of 2018, the yield on the 10-year UST has risen 55 basis points as at April 27, and is currently trading around 2.96% after hitting the “psychological barrier” of 3 percent on Tuesday. Some practitioners argue that the Fed may be nearing the end of its rate hiking cycle and as such, rates are unlikely to move significantly higher from current levels. Others posit however that the 10-year yield will continue to rise given the ongoing strong performance of the U.S. economy in particular (and the global economy to a lesser extent) and rising inflationary impulses, with the recent surge in commodity prices adding to the mix. How do investors therefore cope with the prospects of rising interest rates? How does an investor manage or mitigate the risks to his/her portfolio? A few simple suggestions are offered below.
What can be done?
There are a number of strategies an investor can employ in the face of a rising interest rate environment. These range from the very simple (such as buying bonds with shorter maturity or call dates, investing in short-term money market instruments or buying variable or floating rate bonds) to more sophisticated plays involving the use of derivative instruments (e.g. structured notes or options). For clients already holding bonds (especially long dated fixed rate bonds), it’s not a bad idea to sell now and crystallize those hefty capital gains that have been accumulating when rates were falling, especially if the main objective of the initial investment was primarily growth through capital appreciation. Of course, if the investor is happy with the cash flows currently being provided and is comfortable holding the bond until maturity, then no action is required at this time. With cash in hand and depending on the investor’s outlook and investment horizon, s/he may proceed as follows:
- Buying bonds with shorter maturity or call dates
- Buying bonds with variable/floating coupon rate
- Explore specific structured notes (Equity linked notes)
Shorter dated bonds are less sensitive to interest rate movements than longer dated bonds (meaning the price or value of the short-term bond will fall less than that of a longer-term bond for a given increase in interest rates). An investor can reduce price risk by buying shorter term bonds and enjoy the added benefit of a return greater than would be otherwise available, by simply keeping funds in cash or investing in a money market instrument. However, yields on these instruments will still be relatively lower than those earned on longer dated bonds.
Floating rate bonds are popular in a rising interest rate environment and offer an investor the prospect of higher coupons after each interest reset. The coupon rates on floaters are usually quoted as a spread to a variable benchmark rate (such as U.S. treasury yields or LIBOR) and are usually different for each interest payment period as the variable benchmark rates move.
There are also a number of structured notes that one can explore given the different tides in the market. There has been a significant rally in equity markets globally – particularly in the U.S. Volatility has been rising and many fixed income structures have been designed to take advantage of this market trend. Equity linked structured notes typically give the investor a reward if a pre-established condition is met. In most cases, the condition usually stipulates that the price of a particular asset or the value of a specific index, must stay within a specified range for the reward to be dispensed. During the time period when the condition is not in breach and the asset price is within the stipulated range, the holder is usually paid some form of return on his principal, which takes the form of a coupon. For example, a note may be designed such that if the price of a Netflix stock stays within the range of US$500 to US$700, the noteholder will receive a coupon of 8% per annum. However, should the price exceed US$700, the note will be called by the Issuer. Similarly, if the price falls below $500 on the observation date, no coupon is paid for that period. Alternatively, a note could pay 10% if the S&P 500 and the Russell 2000 indices do not fall below 70% of their initial value on the issue date. These notes have varying tenors and the longer the maturity date, the longer the coupon. Investors should look to stay short as interest rates are rising.
Eugene Stanley is Vice President – Fixed Income and Foreign Exchange Trading at Sterling Asset Management. Sterling provides medium to long term financial advice and investments in U.S. and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org. You may visit us on Facebook or follow us on Twitter and for more information please visit our website www.sterling.com.jm
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