Managing Interest Rate Risk
#Market Strategy — 05.01.2017

Managing Interest Rate Risk

Guy Ertz & Edouard Desbonnets

Until recently, interest rates and bond yields had been falling continuously since the financial crisis. With an expected rise in inflation and increasing economic growth, central banks should normalize their monetary policies. Some (e.g. the Fed) might even raise their policy rates. Bond yields are set to continue their upward trend. Traditional bond investors are at risk as the rise in yields will push down the value of existing bonds. We offer a number of solutions to benefit from rising interest rates and bond yields.

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US

Mr Trump is set to be an inflationary president. Indeed, his policy which is mostly based on a large fiscal package, more protectionism and tax cuts, will push up expected inflation and yields via increased deficits. Inflation expectations and yields have already priced in this anticipated effect. US yields jumped by about 40bp in the few days post-election (from 1.80%) while inflation expectations gained about 30bp (from 2.15%).

We believe the rise is not over as inflation will continue to grind higher in the US via energy prices, a tighter labour market and some potentially difficult discussions on trade agreements.

We think the Fed will respond by becoming more aggressive. We expect two interest rate hikes in 2017, followed by three in 2018, suggesting a Fed fund rate of 2.00% towards the end of 2018.  This is slightly lower than the Fed forecast (2.125%) according to the Fed’s median dot plot, now that the projections have been revised higher in the December FOMC meeting. The terminal rate might reach around 2.5% in 2019.

We have adjusted our yield projections to take into account the new economic environment and a hawkish Fed. Our 12-month forecasts are 2.75% for the 10-year yield and 1.70% for the 2-year yield.

Traditional bond investors are at risk as the rise in yields is pushing down the value of existing bonds. We offer a number of solutions to benefit from rising interest rates and bond yields in the US. We recommend buying Floating Rate Notes (FRN), leveraged loans, short duration High Yield, Credit Linked Notes (CLN) indexed to  short-term rates and Newcits.

 

  • FRN are instruments that provide protection against rising interest rates. They usually pay a quarterly coupon based on the US 3-month Libor (0.99% currently) + spread. Hence, interest payments on FRNs rise when short-term rates go up.  The spread depends on the issuer’s credit rating.
  • Leveraged loans are senior secured corporate loans to high yield companies. They also pay floating coupons, generally indexed to short-term rates. However, leveraged loans are often more senior compared with High Yield bonds.
  • Short duration High Yield is unsecured corporate debt (below BBB-). It is usually considered as more risky than leveraged loans. A shorter duration than the benchmark reduces the negative impact of rising yields.
  • CLNs indexed to short-term rates help investors to benefit from a more aggressive Fed tightening cycle while offering a premium as it is based on a credit portfolio.
  • Newcits offer a fund manager the possibility of going long and short. In this context, we favour macro-economic strategies which can be based on a large number of asset classes (Commodities, Currencies, Interest Rates, etc.). 
     

Eurozone and UK

In the Eurozone and the UK, yields and inflation expectations also surged due to a spill-over effect after the US election. German 10-year Bunds and 10-year Gilts rose about 20bp, Eurozone and UK inflation expectations gained about 13bp a few days after Trump’s victory. Eurozone expected inflation reached 1.70%, a YTD high. However, this level is still too low to trigger a monetary policy shift. We believe that the ECB will keep its policy rate unchanged in 2017 and that it will continue to taper the asset purchase programme because deflation risk has diminished. As a consequence, we think that German yields still have upward potential. Our 10-year Bund target is 0.75% in 12 months.

Turning to the UK, we think that the BoE will leave its policy rate and its asset purchase programme unchanged for the foreseeable future. Our 12-month target on the 10-year Gilt is 1.90%, or an upside of around 50bp from current levels. Consequently, we see more upside at the long-end of the German and UK yield curves. We favour products like Credit Linked Notes (CLNs) indexed to long rates, and Newcits to benefit from the long-end of the yield curve (see section on the US for more details on these investment solutions).
 

Risks to our base case

The above strategies should pay off in a reflation scenario, assuming that the Trump administration delivers. If this is not the case, yields might fall back in a global risk-off sentiment. Products with floating coupons might pay very low coupons. There would be an opportunity cost relative to fixed-income bonds. Investment solutions with credit risk exposure could suffer from downward revisions to growth. Even if we cannot exclude such scenarios, risks remain low.