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Rising rate environments can challenge even the most sophisticated fixed income investor. As we consider the current market juncture and assess its potential impact on liquidity management, we make these key observations:
UK and US interest rates are poised to rise from levels that are near their all-time lows, with the 10-year Gilt yielding 1.81% (as at 29 May 2015). Amid diverging central bank policies, the European Central Bank and Bank of Japan are expected to continue their monetary easing.
When interest rates rise, the market value of previously issued fixed coupon bond holdings will fall as investor demand shifts to new, higher-yielding bonds. But not all securities are created equal. Bonds with shorter maturities, floating interest rates and/or higher yields should experience less dramatic price declines.
During periods of rising interest rates and stable credit conditions, investors can improve the total return of their bond portfolios by shifting into shorter duration and higher-income-generating strategies.
A study of past rising rate cycles and dynamic scenario analysis of potential future rate moves can provide a valuable perspective to an investor managing liquidity through a rising rate environment.
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The directionality of interest rates is a critical determinant of 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 a sometimes unpredictable fashion. In periods of falling interest rates, previously issued fixed coupon securities will typically increase in market value. When rates are rising, those same securities will decrease in value.
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 at the beginning of 2015, 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 Bank of England (BoE) in response to the 2008 global financial crisis.
In any market environment, rising interest rates will have negative repercussions for existing holdings in most traditional fixed income investments. Because rates have been so low for so long, when the current cycle does turn it will present a particular challenge.
This PDF examines the risks of rising rates. We explore how we arrived at the current market juncture and consider prior rising rate periods, using indices as proxies to determine how various fixed income strategies performed in the sterling market. We demonstrate how to use dynamic scenario analysis to better understand the possible return implications of interest rate and credit spread movements. Finally, we outline strategies and solutions to best insulate a short-term fixed income portfolio in a rising rate environment.