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Protect your portfolio from rising rates with the right funds

With interest rates expected to rise next year investors should look to prepare their portfolios ahead of time
November 5, 2014

Interest rates have seemed like a racing certainty for the past two years, yet have stubbornly failed to materialise. However, with economic data showing incremental improvement, the smart money is now on a rise in the second half of 2015. Investors may need to prepare their portfolios ahead of time, not least because a rise in rates may dent some of the areas that have been highly prized for their income characteristics in recent years.

At the start of 2014, the majority of investors believed that there was only one possible direction for interest rates. They would rise, almost certainly at some point in 2014. Yet central bankers have proved reluctant to tighten monetary policy in any meaningful way, and are still hanging on for a demonstrable and sustained rise in wage growth prior to taking action.

They are also mindful of the weakening situation in the eurozone. The European Commission has slashed its predictions for eurozone gross domestic product (GDP) growth, with Germany and France subject to the most severe cuts. Germany's 2015 growth forecasts were cut from 2 per cent in May to 1.1 per cent in November, while France's forecasts were cut from 1.5 per cent to 0.7 per cent. Debate remains as to whether this is short-term weakness prompted by the Ukrainian crisis or a longer-term deflationary trend. Either way, it pushes the resolution of the still-pressing debt crisis further into the future.

As the eurozone's largest trading partner, the UK is unlikely to remain unaffected. Chancellor George Osborne said in October: "The Eurozone risks slipping back into crisis. Britain cannot be immune from that - indeed it is already having an impact on our manufacturing and exports." This contributes to the view that interest rates will remain lower for longer. There is now almost no support for a rise in UK rates prior to the election. The UK yield curve suggests that rates will be below 1 per cent in two years' time and will still be below 3 per cent in a decade.

Most fund managers support the 'lower for longer' scenario. For example, Richard Jefferies, chief investment officer at Cazenove Capital Management, says that central bankers are still looking for reasons not to tighten monetary policy and there will be no move on rates before the election. Phil Milburn, manager of Kames Strategic Bond Fund (GB0033988436), agrees: "The first UK rate rise was originally predicted for the second quarter next year, but now there is unlikely to be a rate rise until September or October."

That said, this does not mean investors can ignore the potential impact of rising rates. Low rates have created an environment in which alternative sources of income - property, UK equity income and most notably, corporate bonds - have been highly prized. If interest rates move, even by a relatively small amount, the income available on these investments becomes less valuable, which may drive prices lower.

The government bond market will take the first hit from interest rate rises. Yields on gilts have been artificially suppressed by lower rates and quantitative easing, and are now unusually sensitive to rate rises. Put simply, if a gilt is paying 2.5 per cent for 10 years, with interest rates at 0.5 per cent, that income stream is worth 2 per cent (2.5 per cent minus 0.5 per cent) a year for 10 years. If interest rates rise to 1 per cent, that income is only worth 1.5 per cent a year for 10 years. This will be reflected in the price of the bond.

High-quality corporate bonds are likely to experience similar difficulties, but here there is an added wrinkle: questions have been raised about the potential for liquidity problems if there is a mass exodus from corporate bond markets. Unlike equity markets, the secondary market for bonds is relatively opaque. James de Bunsen, fund manager at Henderson Global Investors, says: "We hold nothing in the investment grade or government bond areas now. They will suffer when rates go up, and they also just look horribly expensive. We don't expect a rout in the bond markets, but we don't want a lot of it in our portfolios."

However, while higher-quality bonds may be at the epicentre of problems, other asset classes will be affected. Gavin Haynes, investment director at Whitechurch Securities, for example, points to 'bond proxies' - equities that have been bid higher because of their long-term bond-like dividend streams: "These companies may have a high yield, but that will be less valuable with higher rates. This could include areas such as utilities. Investors may be better off looking for dividend growth."

Tim Cockerill, head of research at Rowan Dartington, says that infrastructure investment trusts could also be vulnerable: "These pay an attractive level of income, at around 5 per cent. However, they are trading at significant premiums to the net asset value (NAV) of the underlying holdings in many cases. The average premium is now at around 14 per cent."

Stephen Peters, analyst at Charles Stanley, argues that infrastructure may be protected to some extent by the potential for a rise in the value of the underlying assets, but says investment trust discounts in general are likely to widen and therefore many trusts trading at a premium are vulnerable.

Assets that have qualities over and above their yield - inflation protection, the potential for higher capital growth - are likely to be safer in a climate of rising rates. Mr Cockerill says: "In general, plain vanilla equity income funds that are investing in higher quality companies paying dividends increasing year on year, growing at rates faster than inflation, are likely to remain a good place to be."

Funds to mitigate inflation

 

Perpetual Income & Growth Trust (PLI)

This 'plain vanilla' trust, an IC Top 100 Fund, is managed by Mark Barnett of Invesco Perpetual. Mr Cockerill says that it is one of the strongest in its sector and pays a reliable dividend without being too racy. The trust is up 137.62 per cent over five years compared to an average of 120.76 per cent for the Association of Investment Companies (AIC) UK Equity Income sector.

 

Majedie UK Income (GB00B7FRND86)

Managed by Chris Reid since launch in December 2011, this UK equity income fund doesn't hold all the traditional equity income stocks, such as utilities or pharmaceuticals. Mr De Bunsen says: "It is a multi-cap fund and the manager looks for turnaround stories. As the companies are also paying a dividend, investors are paid to wait for the turnaround to happen." The fund is up 9.8 per cent over one year, compared to the Investment Management Association (IMA) UK Equity Income sector average of 2.2 per cent.

 

Schroder Oriental Income (SOI)

Mr Cockerill says: "This investment trust is yielding a little under 4 per cent and offers the potential for growing income, as well as long-term capital appreciation. It is run by Matthew Dobbs, who is very experienced." It has risen 101 per cent over five years, compared to 29.38 per cent for the wider Asia Pacific ex Japan sector. Dobbs' style is to look for growing companies with strong business models and visible earnings, trading on attractive valuations. He is also happy to seek shares in unloved markets.

 

Argonaut European Enhanced Income Fund (GB00B40QSS95)

Mr Haynes says: "If investors are prepared to take equity risk, looking to Europe for dividend income may be worthwhile. Europe is significantly behind the curve in terms of monetary tightening and therefore European dividend stocks will continue to look attractive. Argonaut European Enhanced Income is currency-hedged, so investors are not exposed to any decline in the euro." The fund is up 48.95 per cent over three years, compared to an average rise of 41.59 per cent for the wider sector. The fund was launched in 2012 so does not yet have a five-year track record.

 

M&G Global Floating Rate High Yield Fund (GB00BMP3SB45)

Stephen Peters at Charles Stanley, says: "This fund invests in high yield bonds that pay a floating rate which moves higher with interest rates rises, and it is run by the well-respected M&G Bond team."

Investors looking to retain fixed-income exposure will be considering both floating rate loan and bond funds, but Peters argues that bonds are superior because they participate fully in the rise in interest rates, whereas some loans may not. The fund launched in September this year and sits in the IMA Sterling High Yield sector.

 

Suggested funds

 Fund/sector12-month yield (%)1-year total return (%) 3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)
Majedie UK Income A4.169.775nana1.54
IMA UK Equity Income sector average2.16544.45366.285
FP Argonaut European Enh Inc A GBP Inc5.246.27948.952na1.71
IMA Europe Excluding UK sector average-2.57641.59339.082
M&G Global Floating Rate High Yield GBP A-H Incnananana1.46
IMA £ High Yield sector average3.05528.38343.917
FTSE All-Share TR GBP0.22434.95160.260

Source: Morningstarm, as at 3 November 2014

 

TwentyFour Income Fund (TFIF)

This investment trust focuses on the less liquid parts of the fixed income market, with a higher income and no interest rate risk. Tom Beckett, chief investment officer at PSigma, says: "This invests in areas such as European asset-backed securities and floating rate notes. It should go up in line with interest rates and it pays a higher income." The trust was launched in March 2013. Over the past 12 months, it has risen 19.74 per cent, compared to a rise of 2.17 per cent for the average trust in the specialist debt sector.

 

TR Property (TRY)

Property funds may slip when interest rate rises are first announced, but interest rate rises do not happen in a vacuum. They will tend to be as a result of an improving economic environment and/or higher inflation. In a more buoyant climate, landlords can raise rates and property-focused funds will tend to do well. Mr Peters believes that TR Property (an IC Top 100 Fund), run by a four-strong team led by Marcus Phayre-Mudge, should benefit over the longer-term.

 

The Renewable Infrastructure Group (TRIG)

Mr De Bunsen identifies this trust as a possible alternative to now expensive infrastructure funds. It is run by the same group as IC Top 100 Fund HICL Infrastructure Company (HICL), one of the sector heavyweights. It invests in renewable electricity with a focus on wind and solar power. The revenues are government-backed, and yields are high and inflation-linked. But unlike broader infrastructure funds, a number of which trade on double digit premiums to NAV, Renewable Infrastructure trades at a premium to NAV of around 4 per cent. The fund has a market cap of around £435m in size and has just started another round of fund-raising to generate a further £250m.

 

Suggested investment trusts

TrustYield (%)1-year share price return (%)3-year cumulative share price return (%)5-year cumulative share price return (%)Discount/premium to NAV (%)Ongoing charge plus any performance fee(%)
Perpetual Income & Growth Ord3.1314.9668.23137.62+0.831.85
UK Equity Income sector average2.8468.11120.76
Schroder Oriental Income Ord3.887.0150.74101.45+0.721.63
Asia Pacific - Excluding Japan sector average-9.095.1029.38
TwentyFour Income Ord5.5819.74nana+6.430.91
Sector Specialist: Debt sector average2.1719.8729.98
TR Property Ord2.8117.7178.5798.10-0.962.06
Property Securities sector average-99.51-99.32-98.39
Renewables Infrastructure Group5.828.28nana+4.23na
Sector Specialist: Infrastructure - Renewable Energy sector average
FTSE All Share TR GBP0.2234.9560.26

Source: Morningstar, as at 3 November 2014