Navigating a rising interest rate environment
After a long period of easy monetary policy, the global interest rate hiking cycle appears to be underway. While escalating geopolitical tensions in Europe has the potential to end this cycle prematurely, the Bank of England (BoE), the US Federal Reserve (Fed) and even the European Central Bank (ECB) are all currently signalling an intention to tighten policy.
How the hiking cycle will develop, and what terminal rate we expect the various economies to reach, are heavily debated topics. However, it is clear that following the unrivalled global economic support we saw in response to the Covid pandemic, policymakers are now more concerned about the direction of inflation, which has been compounded by the geopolitical tensions that have caused a surge in commodity prices. To this effect, global monetary policy does look set to return to a more normal state, which means a period of rising interest rates.
The impact of interest rates on bond markets
The direction of interest rates is critical to determining the performance of fixed income securities. As rates fall and rise in cycles, bond markets can turn from boom to bust, creating or destroying investment value in sometimes unpredictable ways.
For more than 30 years, UK interest rates have been in a period of secular decline. Since March 1990, when yields on the 10- year Gilt reached 12.1%, interest rates have trended downward, towards all-time lows of 0.08% on 4 August 2020, and they remain well below historical averages. These extreme low levels – which included negative real rates on the 10-year Gilt for substantial periods – resulted from unprecedented monetary stimulus provided by the BoE in response to the global health pandemic, including emergency rate cuts and ambitious quantitative easing (QE) programmes.
However, the rates backdrop changed dramatically since the pandemic lows. In December 2021, the BoE became the first major developed market central bank to lift policy rates with an 8-1 vote to raise the Bank Rate from 0.1% to 0.25%. The Monetary Policy Committee’s (MPC) decision was driven by its remit to meet the 2% inflation target and maintain price stability over the medium term. Because interest rates had been so low for so long, the transition to a rising rates cycle does present a particular challenge.
How have fixed income markets responded to the new environment?
In any market environment, rising interest rates will have negative repercussions for existing holdings in most traditional fixed income investments. The extremely low levels on risk-free rates in the pandemic period forced investors to accept lower yields on some of their assets and to also seek yield in riskier securities. The Bloomberg US Corporate 1-3-year credit spread (Option Adjusted Spread or OAS) index tightened significantly from 3.9% in March 2020 at the start of the pandemic, hitting just 0.31% on 25 May 2021.
The pattern is the same for sterling spreads where the OAS to Government bonds spread for the ICE Bank of America 1-3 Year Sterling Corporate Index tightened to just 0.50% by 31 December 2021 to 0.81% as of 4 February 2022. Spreads started to widen as the interest rate rising cycle began and we could expect to see further spread volatility, from very low pandemic-era spread levels, as the market tries to predict the pace and pattern of the hiking cycle. It is possible that as investors sell fixed income securities in anticipation of higher rates, sales will not be limited to risk-free Treasuries alone, and credit products may see spreads widen even if corporate fundamentals remain relatively strong.
Insulating a fixed income portfolio from rising rates: Ultra-short income
For investors with shorter investment horizons (especially those with potential near-term cash needs) or those seeking to protect profits realised from longer duration strategies, mitigating potential volatility during the rising rate environment is the key priority. As rates rise, these investors risk losing money from both higher rates (duration) and from widening credit spreads if they have not hedged their portfolios effectively. To that end, it’s vital to consider the key elements of investing in a rising rate environment – duration, income and credit spread exposure.
One way of managing interest rate duration, credit duration and income is to employ an ultra-short duration strategy like JGST, the JPMorgan GBP Ultra-Short Income UCITS ETF. JGST might be suitable for investors that do not require same day liquidity on their funds and are willing to take on additional risk versus a traditional money market fund. The ETF typically has durations between three months and one year, has a shortterm benchmark (ICE BofA Sterling 3-Month Government Bill Index) and exhibits lower performance volatility than shortterm bond funds. Due to its slightly longer duration of up to one year (relative to money market funds) and mark-to-market accounting, unrealised losses can occur when rates rise, causing negative returns. However, because of the structure of these portfolios and their short duration, negative returns should be relatively short-lived. Therefore, over longer term time horizons, ultra-short income strategies like JGST have tended to outperformed money market funds. Moreover, from an ESG perspective, JGST promotes ESG characteristics in line with JPMorgan’s SFDR framework for Article 8.
For this strategy to work, cash segmentation is crucial. Investors need to know that they have enough operational cash for their day-to-day needs before they can consider deploying cash for extended periods in strategies that offer better financial benefits, such as ultra-short income. See our paper, Leveraging the Power of Cash Segmentation, for more information.
JGST is also appropriate for those fixed income investors in longer duration strategies who are looking to mitigate interest rate risks associated with this area of the market. By its nature, ultra-short duration strategies provide some insulation from the capital losses incurred by rising interest rates to fixed income investors. Additionally, given that ultra-short duration strategies invest in bonds with shorter maturities, investors can benefit from higher yields sooner.
Active management is also key for investors looking to navigate the uncertainty and volatility caused by the spectre of rising rates. Actively managed ultra-short duration strategies like JGST, backed by professional portfolio managers and dedicated proprietary credit research, can look to take advantage of market opportunities and mitigate risk by managing duration, sector rotation and security selection. Given the uncertainty around the market’s reaction to tightening financial conditions, this flexibility could make a significant difference to returns.