Is this the end?

16 June 2015
The question I get asked most often is whether an interest rate rise will wipe out bond fund performance. My answer reads something like this.

The truth is no one can predict what exactly will happen in the event of a rate rise. There is no guarantee of a rate rise any time soon, and while most are predicting one by the year end, the fact that it’s been pushed back so many times over the last six years makes rate hike predictions less credible.

Press headlines predicting ‘bond bubbles’ have been around for a while but it really isn’t as simple as that. Yes, interest rates are likely to rise over the next few years but equally, they’re likely to splutter too. Bond prices move up and down, that’s in their very nature and if we are genuinely moving towards Armageddon, then yields would be rushing towards pre-2007 levels of 5% and we don’t expect yields to rise above 3%.

Rate rises have already been priced into markets and although a marginal rise would impact the price of bond funds (in particular those with longer durations), we expect the impact to be minimal and that conditions will quickly normalise based on the strong global economic foundations that are firmly in place.

In addition, demand for bonds is unlikely to weaken anytime soon. The requirement to protect against the threat of significant  market volatility as you approach retirement  ensures a steady, robust demand for safe havens such as bonds. Continued strong growth in Liability Driven Investment (LDI) strategies which naturally support the increased purchase of gilts has also driven demand and isn't going to change overnight. As a recent example, the May 2015 auction of index-linked bonds maturing in 2058 saw the strongest demand for Government debt since February. 

Are we doomed?

  • We expect any rate rises to be marginal and gradual.
  • Rate rises are not a game changer  and the focus should be on the bigger economic picture.
  • Within the Governed Portfolios (GPs) and Governed Retirement Income Portfolios (GRIPs) we are underweight fixed interest and have no exposure to conventional gilts.
  • We are adopting a range of strategies to mitigate the impact of interest rate risk.

Managing interest rate risk

So how do we manage this risk in our GPs and GRIPs? Do we rush out of fixed interest and move money into other asset classes? Well, we believe that could be an expensive mistake at the moment, not to mention a significant shift in the risk spectrum. Bonds continue to offer diversification benefits to equities and property and can help combat the effect of unexpected market falls. So our approach is to adopt a number of different strategies to mitigate the short-term impact of a rate rise within fixed interest.

We are currently adopting an underweight fixed interest position in the GPs and GRIPs. The flexibility we have around our ability to apply a tactical overlay means we can move in and out of assets, reducing and increasing exposure to take account of market conditions. For example we have previously utilised cash, high yield and conventional gilts on a tactical basis and can shift duration allocation if required. 

We operate a diversified approach to fixed interest investments. Within the GPs, we use index-linked and investment-grade corporate bonds on a strategic level. We are currently further diversifying by using global high yield and short duration global high yield on a tactical asset allocation basis.

In the GRIPs, we include UK high yield as a strategic holding alongside index linked and investment-grade corporate bonds and currently have no exposure to conventional gilts. High yield bonds benefit from being less affected by interest rate movements. Indeed, we believe a greater threat to credit funds would be a decline in the economic outlook and a turn in sentiment but as Central Banks appear supportive of growth, we believe there is less chance of this happening.

The investment-grade and index linked funds held within the GPs are all duration-matched to the term of the portfolio. Each of these underlying funds has their duration reset on an annual basis to ensure an ongoing match to the portfolio the client is invested in.

By targeting term as well as risk, it means that clients are gradually moved into shorter duration fixed interest funds the closer they approach retirement. This mitigates the risk of longer duration assets being hit the hardest from a base rate rise and reduces the impact of interest rate risk for our policyholders.

We also diversify outside of fixed interest by investing in equities and commercial property adopting a truly 'multi-asset' approach.

Shortening the duration of a bond fund can limit the impact of price falls in the event of a rate rise. But shortening the duration too aggressively and too early can impact short-term performance so it’s an important balance to get right.

The current mandates of the fixed interest funds in the GPs and GRIPs allow us to be up to one year long or short vs the benchmark. As we expect base rates to rise this year, we are short by the full year across the board so the duration matched funds are all effectively sitting at 4, 9, and 14 years. 

Royal London Asset Management – an award-winning fixed interest team

When it comes to managing fixed interest assets, Royal London Asset Management (RLAM) has a highly experienced fixed interest team that has developed a reputation as one of the UK’s leading managers of government and credit bonds and has delivered strong performance through changing economic conditions and business cycles. The team boasts an average of 14 years’ investment experience. RLAM look to use their in-depth market knowledge to exploit investment opportunities and add value by adopting a wide range of strategies and not over-relying on credit rating agencies.

UK rate rises will not wipe out bond fund performance

Eric Holt, manager of the RLP Sterling Extra Yield Bond fund, considers the future of bond funds in the face of a rate rise. This fund is a strategic holding in the asset allocation of the GRIPs. 

About the author

Ryan Medlock

Investment Proposition Manager

Ryan’s remit includes speaking investment matters at adviser events, regularly contributing to Royal London websites and trying to beat his colleagues in the fantasy fund manager competition.

Last updated: 09 Jun 2017

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