Interest rate strategies for a low and rising interest rate environment

There are several options available for investors who are relying on fixed income investments to generate income in the current extremely challenging environment – characterised by low short-term rates and rising longer-term interest rates.

Short-term fixed income funds and private debt funds are two examples.  Both seek to deliver a healthy return above cash and term deposits.  They achieve this in a variety of ways, chiefly by gaining exposure to different investment risks.

In addition, active management is an important source of return from short-tern fixed income funds.  And exposure to the illiquidity premium is a source of “excess” returns in relation to private debt funds.

Crucial to success in the current environment is an investor’s perception and measurement of risk.

In measuring risk, investor focus should be on avoiding permanent loss of capital, rather than volatility of capital and investment returns.

So long as permanent loss of capital is appropriately managed, investors should be prepared to accept a higher volatility of capital from their fixed income investments, along with less liquidity. 

Such an approach will likely result in higher and more consistent levels of income in retirement.

Short-term fixed income funds

Short-term fixed income funds are actively managed fixed income funds that seek to take advantages of opportunities in short-term fixed income and credit markets to generate returns above cash and term deposits.

Although short-term fixed income funds target a lower average portfolio duration, they are often able to invest in securities that have up to 5 years until they mature. (Duration is a measure of a security and portfolio’s sensitivity to movements in interest rates.  The higher a portfolio’s duration the more volatile it will be.  A portfolio rises in value when interest rates fall and decreases in value when interest rates rise.  Duration is measured in years.)

The target duration on “short-term fixed income funds” can vary materially, from less than 1 year and up to a maximum of three years.

Likewise, credit quality can vary significantly between different funds, ranging from high quality investment grade exposures to sub-investment grade (High Yield).  On a more technical note, and often not considered, the credit duration of these funds can also vary, particularly in relation to the maximum term of credit security invested in.  Like interest rate duration, credit duration is measured in years and the higher the credit duration the more volatile will be the security or portfolio.

Some of the short-term fixed income funds can also invest into inflation-linked securities, an additional diversifying source of return and risk exposure for a portfolio. And maybe a valuable addition to portfolios in the years ahead.

Funds also differ in the countries they invest into, from domestic markets (e.g. New Zealand and Australia) to internationally, including the emerging markets.

Therefore, there is a very broad spectrum of Funds in this category and fund selection should be undertaken relative to risk tolerances and any investment mandate constraints where applicable e.g. limits on credit quality.

In my mind, a broad investment mandate is better.  This provides more opportunity for a manager to add value and manage portfolio risks – should they have the skill, resources, and capabilities to do so.

Lastly, short-term fixed income funds are generally highly liquid, and more liquid than term deposits.

My approach would be to implement as broad an investment strategy as possible given the constraints of fees, risk tolerance, and access to appropriate vehicles.

There are a number of these funds in the marketplace. For a Kiwi Investor, a strategy denominated in New Zealand dollar terms should be preferred.

Private Debt Funds

For those investors with a longer-term investment horizon and can maintain within their portfolio illiquid investments, Private Debt Funds offer the potential to boost returns, not only in the current investment environment, in the future as well.

Typically, the term “private debt” is applied to debt investments which are not financed by banks (non-bank lending) and are not issued or traded in an open market.

Private debt falls into a broader category termed ‘alternative debt’ or ‘alternative credit’, and is used interchangeably with ‘direct lending’, ‘private lending’ and ‘private credit’.

Within the private debt market, investors lend to investee entities – be they corporate groups, subsidiaries, or special purpose vehicles established to finance specific projects or assets – in the same way that banks lend to such entities.

Private debt investments are often used to finance business growth and provide working capital.

Private Debt Funds invest in loans to a wide range of borrowers such as public and private companies, infrastructure providers, property developers, and project finance groups.

Private Debt has been one of the fastest-growing asset classes.  Part of this growth reflects a change in debt markets since the Global Financial Crisis (GFC) and a corresponding demand from investors, attracted by the return potential and a broader set of credit investment opportunities to invest in.

Illiquidity Risk Premium

To generate returns over cash and term deposits investors need to take on more risk. 

Arguably the most efficient way to take on more risk is to invest into a diversified range of risk premiums.  The best known risk premiums are value, growth, momentum, and to a lesser extent low volatility.  Equity markets, interest rates, and credit are also risk premiums. Good active managers will add value over and above, or independently, of all these premiums.

There is also an illiquidity risk premium, which is often underrepresented in portfolios.

The illiquidity premium is the additional compensation to investors for not being able to access their capital for a specific period.

As a result, illiquid investments, such as Private Debt, should offer a “premium” in the form of higher yield expectations.

These higher relative yields could be a helpful in boosting income in the current environment and in the future.

Measuring Risk

“Risk means, more things can happen than will happen”, Elroy Dimson. 

An investor’s perception and measurement of risk are important in managing an investment portfolio.

Perception toward risk is critical. For example, often, adding new “risks” to a portfolio leads to a less risky portfolio. 

Most importantly, in managing investment risks, the ability to think in terms of probabilities is important.  This involves understanding and appreciating the likelihood/chance of an event occurring and then the expected impacts of that event occurring to all parts of the portfolio.

In relation to measurement of risk, investor focus should be on avoiding permanent loss of capital, rather than measuring risk as fluctuations in capital and returns.

Warren Buffett understands this concept of risk very well.  And, it has not done him any harm implementing this approach to risk!

Accordingly, investors would do better thinking along these lines in relation to risk.

So long as permanent loss of capital is appropriately managed, investors should prepare to accept a higher volatility of capital from their fixed income investments and less liquidity. 

Such an approach will likely result in higher and more consistent levels of income in retirement.

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

source: Forbes.com

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