Interest Rates and Investment Portfolios

By June 17, 2018 March 25th, 2019 Insights - Financial adviser

Global interest rates are on the rise, so what are the implications for investment portfolios? To answer this key question, we look at not only the pecking order of interest rate sensitivity on each asset class (otherwise referred to as “duration” risk), but also the sensitivity of various sectors within the equity market.

The Yield Curve: the market for interest rate expectations

In quantifying the market’s expectations for interest rates into the short, medium and long term, the yield curve is an essential guide to a shifting rate environment. This is because the yield curve reflects the expectations of the market in aggregate in terms of where interest rates are headed. A “normal” yield curve is one that is shaped in a convex fashion, effectively showing that longer maturity bonds have a higher yield compared to shorter-term bonds. This makes sense due to the risk associated with time. However also factored into the “curve” are interest rate expectations looking into the future.

Over the last 12 to 24 months we have seen the yield curve in US shift upwards, a reflection of progressively increasing expectations of future rate rises. Even in our domestic economy, we inevitably see increasing upwards pressure to our yield curve, as the currency comes under pressure and the RBA is forced to act in order to protect it.



Asset Class Implications

In assessing the implications at the asset class level, we need to consider the “duration” of various competing investments. The basic concept is, the more fixed and predictable an assets cashflows, the greater the duration, and the further the asset has to fall in a rising rate environment.

At one end of this scale, if we had locked in a fixed annuity payment of exact cash flows over the long term, we would have most to lose; while at the other end of the scale, if we have a small cap mining stock of uncertain and unstable cash flows, we would have little to lose given its valuation is more associated with its growth expectations.

While this may sound counterintuitive, that is, the more defensive the asset the greater the potential downside in many cases, it makes sense when you consider that fixed cash flows are worthless in a rising interest rate environment. This is because inflation is usually increasing and money can be invested elsewhere at better rates.



Direct Equities Implications

Equity portfolio managers need to think about how this new interest rate regime translates to their portfolios. Again the key here is to identify which assets have the most certainty and stability around cash flows, and hence have most to lose under a rising rates scenario.



Positioning Portfolios

Interest rates are just one very important variable likely influencing portfolios over the medium to long-term. It is also worth remembering that this effect is only one variable of many that are likely to play out. Changes in interest rates are also in the context of the global macro-economic environment, and this will inevitably include prospects for all the major economies, particularly the US and China, commodities, the Australian Dollar, credit market conditions, and so forth.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

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