Bonds may be bashed but equities could be winners if the Federal Reserve moves this autumn
As the Federal Reserve convenes once again this week to discuss whether interest rates should be raised from their rock-bottom lows, many investors are sounding out the potential implications of a rate hike on their portfolios.
Pressure on the Fed to begin raising rates is certainly mounting. Data coming out of the US shows an economy that is well on the way to good health, and it is becoming harder for the Fed to justify maintaining the base rate at 0.25 per cent.
Put in place in December 2008, during the depths of the credit crisis, this level was supposed to be an emergency measure and the central bank has said that normalising policy is now a key aim.
Federal Reserve chair Janet Yellen has indicated she is on course to raise rates this year, and as a similar positive picture has emerged of the UK economy, the Bank of England’s Mark Carney has said he will likely follow suit.
Consensus expectations among experts are for the first rate rises to begin in the US in December, although a few are betting on an earlier move, perhaps in September. The UK is expected to begin early next year, potentially in February.
At the moment, analysts are generally suggesting rate rises will come in small increments of around 0.25 per cent – so central banks can test the waters – and may peak around 2.5 per cent in several years’ time. These are much lower levels than in the past, when rates went up to 20 per cent at times.
Raising interest rates will mean higher borrowing costs for businesses, and for ordinary people (with variable rate mortgages or interest charging credit cards).
This will affect different parts of the investment universe, with some negatives and some positives.
Rising interest rates are a sign that the US and UK economies are strong, so it logically follows that companies doing business in those countries will see better times. Medium sized companies tend to do more business on the ground in the UK than larger companies, so investors could look at popular, good performing funds including the Franklin UK Mid Cap and Neptune UK Mid Cap.
“Funds that should do well are those investing in equities in the economies where the rate rises are happening – so the UK and US in the immediate future,” says Juliet Schooling Latter of Chelsea Financial Services.
SLOW CLIMB FOR EQUITIES
But investment is never this simple. Equity markets are already near record highs in those countries. And after years of unusual economic policy – such as QE and record low rates – no one can predict the effect.
“Rising rates mean central banks are confident the economy is strong enough to withstand them – so good news – but we are in uncharted territory and no-one really knows how it will pan out,” Schooling Latter says.
It is likely investors will take a softly-softly approach and wait until any rate rises are bedded in before moving their portfolio or putting more cash into markets. So investors should not expect any immediate dramatic upside for equities.
But one sector which is highly likely to do better in a higher-rate world is banks and money lenders. “They can charge more for lending than what they pay for deposits – that difference will widen – and to that end you could look at funds which invest in banks,” says Sheridan Adnams of The Share Centre.
Schooling Latter highlights the Jupiter UK Growth fund as one which is heavily invested in banks. There is also the GLG Undervalued Assets fund, which holds other financial stocks such as ICAP and Tullet Prebon which have activities that will be boosted by higher interest rates.
BAD NEWS FOR BONDS
Rising interest rates cause bond prices to fall, so are usually negative for bond funds generally. This, alongside the mostly poor returns found in many parts of the fixed income market, means some experts are advising against holding these funds at all.
However, for those who do have bond holdings in their portfolio, it is worth considering that bonds have built-in sensitivity to interest rates, known as “duration”.
This is measured in years (say, six years, or 10 years) and is set when the bond is first created and sold to investors. The longer the duration on a particular bond, the more sensitive it will be to changes in rates and the more its price will fluctuate. So given interest rate rises are expected soon, short duration bonds are a better choice.
However, there is a chicken and egg problem with finding lower duration bonds. Because people know interest rates will rise, short duration bonds have been popular, and so the pay-off fund managers are getting from buying them is lower.
This means there is a trade-off between choosing lower duration bonds, and getting a good return.
Investors should check the duration level of their fund (it should be detailed on the fact sheet).
BOND FUND CHOICES
One running relatively low duration is the Jupiter Strategic Bond fund, at 4.5 years. “This is a low duration bond portfolio that has the flexibility to be global,” says Adnams. Another bond fund which is often tipped by experts is the Henderson Strategic Bond fund. This has a similar duration level, at 4.6 years.
Another alternative Adnams suggests is “floating rate” bonds, which raise or lower their coupon payments in tandem with interest rates. “These funds get an uplift when rates rise, they keep apace of it.”
A good choice in this category is the M&G Global Floating Rate High Yield fund, Adnams says. “They can look around the world and take different positions.”