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How Can You Prepare Your Portfolio For a Rise in Interest Rates?

October 2017

Tags: Macro Economics

Rising prices, frozen wages and rock bottom interest rates. The latest report from the Bank of England suggests that everyone is beginning to feel the pinch.

The official measure of inflation, the Consumer Prices Index (CPI) is running at 2.7 per cent. That’s far above the Bank of England’s two per cent target for the measure, with rising prices for clothing, airfares and electricity helping to push up prices. But despite evidence that these price rises are affecting families’ ability to save, the Bank of England has not deployed its main weapon against inflation; a hike in interest rates.

The Monetary Policy Committee (MPC) voted overwhelmingly to keep rates at 0.25 per cent in May, with only outgoing committee member Kristin Forbes voting for a rise. 

While continued low interest rates are good news for those with high debts and poor news for savers, investors need to keep an eye on when rates might rise and position their portfolios accordingly.

When interest rates rise, popular wisdom suggests that the price of stocks tends to fall. That’s because companies tend to be servicing debts and the price of their debt goes up with rising rates, making it harder to make a profit.

For bond investors, too, rate rises can be bad news. When interest rates rise, bond yields rise too, so new bonds on the market offer more attractive income rates than existing investments. The price of existing bonds falls, which affects investors’ portfolios.

These are sweeping statements, however. They need to be examined more carefully before investors decide how to position their portfolios. To add to the difficulty of working out what to do, current political and economic uncertainty makes it hard to work out when rates might rise and by how much.

Bank of England Governor Mark Carney, warned in the latest inflation report that many of us are unprepared for rate rises, which might come more quickly than expected. His opening remarks stated that “if the economy follows a path broadly consistent with its central projection, then monetary policy could need to be tightened by a somewhat greater extent over the forecast horizon than the very gently rising path implied by the market yield curve at the time of the forecast”. 

To put that more simply, if the economy does what the Bank expects, interest rates might rise faster than the market is predicting. 

"The market is complacent about inflation. We believe that while monetary policy remains inappropriate for the prevailing economic conditions, it continues to be a real risk,” says James Mahon, co-manager of the Church House Investment Management’s (Church House) Tenax Absolute Return Strategies Fund.

“If inflation starts to rise, there is a risk that policymakers have to move quickly. A rapid rise in interest rates has often been the trigger for recession. It would prove a potentially catastrophic shock for bond markets and would certainly derail sentiment in the equity market.”

However, some economists believe that the Bank will not move fast to raise rates, despite rising prices.  “We maintain the view that the Bank of England will most likely sit tight on interest rates through 2017 and 2018 - and very possibly well beyond,” said Howard Archer, chief European and UK economist at IHS Markit.

“We believe the Bank of England will end up remaining tolerant on the inflation overshoot given likely limited UK growth and the prolonged, highly uncertain outlook that the UK economy will face as the government negotiates the exit from the EU.”

With opinion divided on whether rates will rise, and when, investors need to ensure that their portfolios are prepared.  Often, when rates rise, the stocks that do well are cyclical stocks such as technology and energy companies, as rate rises often come at a time of strengthening economy. 

However, this may not be the case if rates rise purely due to a desire to control inflation, rather than due to positive economic news.  Defensive stocks often tend to pay high dividends, and may be victims of sell-offs if rates rise, so this is worth bearing in mind as well. Banks and insurers are traditional winners from rising rates. 

One thing to check with individual stocks is how much debt they are holding, as indebted companies will pay more to service their debt if rates rise.

As well as checking your equity mix, look hard at the bonds you hold. Interest rate rises are likely to hit your bond portfolio. However, there are ways to hedge against this, such as investing in Floating Rate Bonds, which can parallel rising rates, depending on the benchmark they reference. Ordinary investors can access these using Exchange Traded Funds (ETFs). It may also be worth ensuring that the bonds in your portfolio have an array of different maturities, since you can then have bonds that mature at different times and can be reinvested at new higher rates. 

Above all, the trick is to be agile in a period such as this. Ensure that you keep abreast of economic news and are ready to move your portfolio when rates begin to rise. Rising rates are not something to be feared for those who understand how to counter them.

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