If you have mortgage debt make sure you have the most cost efficient option and consider paying it off early
Shorter duration and flexible bond funds tend to be better placed for a rising rate environment
Diverse exposure to equities can help your investment portfolio outpace inflation and interest rate rises
After more than a decade of low interest rates, the Bank of England has increased interest rates twice in the space of three months, to 0.5 per cent. The Bank is trying to curb inflation, so a rise of 1 per cent is expected by the end of the year. Although this is relatively low historically, it has implications for investors and asset owners.
One of the main areas this will affect is property with mortgages. Variable rate and tracker mortgage interest rates could increase payments by hundreds or thousands of pounds a year. Jason Barefoot, chartered financial planner at Ascot Lloyd, says that it is very important to be able to make the mortgage payments on your main home. You should ensure that the mortgage you have is the most cost-efficient option, and if it is a variable or base rate tracker consider finding the best fixed rate available and locking it in for a period of time.
If you are coming to the end of a fixed-rate deal, it may be possible to secure a new deal up to six months before your current deal ends.
Low interest rates have meant that until recently it has probably been more profitable to invest surplus cash in assets such as equities over the long term rather than over pay mortgages. But now, if you have surplus cash it could be worth making over payments for security, argues Barefoot. However, before making over payments, check to see if there are penalties for doing this and only over pay as much as you can without being penalised. If there are repayment penalties this could also be a reason to switch to another mortgage product.
If you do not want to stop saving or miss out on the long-term potential of markets, Dale Scorer, senior financial planner at EQ Investors, suggests splitting surplus income between investing and saving, and making overpayments. This way you will pay “the mortgages down quicker as well as continuing to save monthly.”
If you have buy-to-let properties with rising mortgage costs it could be a good time to re-assess your case for investing in them. Rising interest can cause house prices to go down though this is likely to be more of a gradual process. Barefoot says that reasons to consider selling or reducing your buy-to-let exposure include if the rents don’t cover the costs or the profits have been reduced. You need to consider factors including the size of the mortgage and how long it has to run, and whether you could increase rents to cover higher mortgage costs. Also, what is the purpose of the property and its income – is it a key part of your current and or retirement income meaning that higher mortgage costs are worthwhile?
And if you sell buy-to-let properties how much capital gains tax (CGT) will you incur? If this is very substantial, higher mortgage costs could pale in comparison. For example, “if you have just one buy-to-let property and are not over exposed you should be ok with rising rates,” says Barefoot. “It is also hard to ignore the supply and demand case for buy-to-let property.”
If you realise a gain when you sell buy-to-let property, you can offset losses made on assets from the current tax year against this. And you can carry forward unused losses from previous years if you reported them to HM Revenue & Customs (HMRC) within four years from the end of the tax year in which you made the disposal. You can also offset any remaining gains against your annual CGT allowance which is currently £12,300. If you plan to sell more than one property, consider selling them in different tax years so you can use your annual CGT allowance and any losses for more than one property.
Also see What's the best way to transition from rental income to investment income? (IC 11.02.22)
Contributions to defined contribution pension schemes can extend your basic rate tax band by the gross value of the contribution so that the greater amount of income that falls within it, the less tax you will pay. If you earn in excess of £50,000 a year income above this level is taxed at the higher rate of 40 per cent. But if you make a pension contribution scheme equal to the excess above £50,000, the basic rate band is extended to value of the gross contribution.
When CGT, the chargeable gain – the net gain minus the permitted allowance – is added to your income for that tax year to determine how much of it falls within the basic and higher-rate bands.
“For example, if you earn £75,000 from employment income and have a chargeable gain of £15,000 from the sale of a buy-to-let property in that tax year, your total taxable income is £90,000,” says Barefoot. “£25,000 of your employment income is subject to higher rate tax at 40 per cent and all the chargeable gain from the buy-to-let sale is taxed at 28 per cent [the higher rate for residential property sales]. But if you make a £40,000 pension contribution – £25,000 excess income above £50,000 plus the £15,000 chargeable gain – your basic rate tax band is extended to £90,000. This means that all your employment income and the chargeable gain fall within the basic-rate tax band so you pay CGT of 18 per cent [on the gain].”
To contribute £40,000 to your pension, you would invest £32,000 and it would be grossed up to £40,000 after basic rate tax relief is applied. When doing your self-assessment tax you would inform HMRC of the gross £40,000 pension contribution and it would send you a cheque for £8,000 or adjust your tax code.
But you cannot put more than you earn into a pension each year, and relevant earnings exclude rental income and dividends. At most, you can contribute £40,000 a year unless you have unused contributions from the previous three tax years that you can carry forward. Pension contributions made by your employer on your behalf also count towards this limit.
If you reinvest taxable gains in Enterprise Investment Schemes (EIS) they are deferred for as long as this money stays invested. You can defer gains made up to three years before and one year after the EIS investment. When you realise your EIS investment the gain comes back into charge and you pay CGT at the prevailing rate. But if you are in a lower tax band at that point because, for example, you have retired you might pay less tax than if you had paid it as soon as you sold the property. Or when you realise your EIS investment you could reinvest the proceeds in another EIS and continue to defer the gain.
However, EIS investments are typically early-stage small companies so very high risk and not suitable for most investors.
Lower risk and income assets
A rise in interest rates does not necessarily mean that interest rates on cash will increase substantially, if at all. But some providers will increase rates so you should search for the best ones on comparison websites such as moneyfacts.co.uk, moneysupermarket.com and comparethemarket.com. However, as rates may rise again Laura Suter, head of personal finance at broker AJ Bell, cautions against locking up your cash in fixed rate restricted access accounts even though they pay much higher rates than instant access accounts. “If you lock in a rate now you’ll miss out on any future base rate rises,” she explains. So it could be worth waiting at least a few months before locking up your money to secure a higher rate of interest.
Even after any rises, cash account interest rates are still likely to be far lower than the rate of inflation. Consumer price index (CPI) inflation is currently 5.5 per cent and expected to rise to over 7 per cent by April. So advisers suggest not holding more in cash than necessary. If you are working, they suggest holding cash in instant access accounts worth three to six months of your essential expenses. If you are retired, they suggest holding larger amounts, such as up to two years’ of your expenditure.
When you have such an emergency cash fund in place, investing money you do not need to access for at least five years gives it a better chance of beating inflation.
Rises in interest rates lead to bond yields rising and their prices falling. But Alex Funk, chief investment officer at Schroder Investment Solutions, argues that there is still a place for some fixed income in investors’ portfolios to provide protection. For example, assets such as US Treasuries can provide safety during extreme uncertainty. But he suggests holding fixed income as one part of a very well diversified portfolio, and reducing the interest rate sensitivity of your holdings in government bonds. Ways to do this include lower duration funds such as Royal London Short Duration Gilts (GB00BD050C73).
For corporate debt exposure, he suggests a fund with a flexible investment mandate. Strategic bond funds’ managers can invest across the debt spectrum in an unconstrained way, focusing on the areas that look best and avoiding less desirable ones. This means that they can be in a better position to navigate rising interest rates than managers of funds which only focus on one type of bond. However, strategic bond funds can be higher risk than traditional corporate bond funds, so are not necessarily suitable for lower-risk investors.
Funk holds Schroder Strategic Credit (GB00B11DP098) in the portfolios he runs and we include a number of strategic bond funds in the IC Top 50 Funds including Allianz Strategic Bond (GB00B06T9362) and MI TwentyFour Dynamic Bond (GB00B57TXN82).
However, if you need income and can tolerate more risk, Justin Oliver, deputy chief investment officer at Canaccord Genuity Wealth Management, says that UK equity income might be better than bonds. This, on average, currently offers a far higher yield and there is potential for dividends to grow over time. He suggests investing in this via LF Montanaro UK Income (GB00BJRCFQ29) which mainly invests in UK small and medium sized companies, offers exposure to growing dividends and has an attractive yield.
“The best asset in current environment is equity markets and maybe smaller companies are where the best opportunities are,” says Oliver. “Historically [they have provided] better inflation protection, and the UK looks good. But if [they] are not profitable they might be more susceptible to an increase in the discount rate.”
He also suggests infrastructure investment trusts some of which have inbuilt inflation links. Oliver argues that Cordiant Digital Infrastructure (CORD) and Digital 9 Infrastructure (DGI9) in particular could be could be good options because “everyone's using more data [and that is] not going to change.”
However, infrastructure investment trusts can trade at high premiums to their net asset value and if you buy them at those levels thereafter their share price and premium could fall. Also assess what projects they invest in, and whether these have debt, what its structure is and how expensive it is, even if the investment trust itself does not have much debt, known as ‘gearing.’
Oliver adds: “We haven’t made wholesale adjustments. Inflationary pressures are likely to ebb globally so keep a watching brief but don’t overreact.”
Higher returning assets
US and tech stocks have experienced sharp falls this year because growth companies are typically valued based on expectations about the future earnings they will make over the next several years. “However, with the cost of capital rising, assumptions about the value of future earnings in today’s money are changing so the sky high valuations that many tech stocks have been trading on are now being called into question,” says Jason Hollands, managing director of online investing service Bestinvest.
The UK market has little exposure to tech and has performed better this year. It includes a number of banks, and financial services, energy and commodity companies – sectors which can be resilient when inflation and interest rates are rising.
“Banks in particular look appealing again after many years in the wilderness,” says Hollands. “The decade of ultra low interest rates since the global financial crisis has been painful for banks, squeezing the margins they made between the rates they charge borrowers on loans and the returns they earn investing deposits in short-term money-market securities. However, the start of an interest rate hiking cycle now opens up the prospect of margin expansion and surging profitability. Bank shares have rallied hard since the first [UK interest rate] hike in December, but the rebound could have much further to run. Bank share price valuations remain low, especially when compared with the expected growth in their earnings from 2023 onwards when rates are forecast to be much higher than now.”
Ways to get exposure to potentially under valued UK companies include JO Hambro Capital Management UK Dynamic (GB00BDZRJ101) which had about 28 per cent of its assets in financials at the end of January. Temple Bar Investment Trust’s (TMPL) managers also invest in the UK market via a value approach, and financials and energy accounted for about 20 per cent and 17.5 per cent of its assets at the end of January, respectively.
Funk suggests in increasing your diversification within equities with exposure to equities across the world including in emerging markets, and cyclical areas in Europe and the UK. As well as value, he suggests holding high quality businesses that don’t have much debt and can pass on cost increases to consumers. Ways to get exposure to these include BlackRock European Dynamic (GB00BCZRNN30).
He also suggests exposure to other assets including commodities, because when inflation starts increasing there is demand for these. WisdomTree Broad Commodities (AGCP) is an exchange traded commodity which tracks Bloomberg Commodity index. This is broadly diversified and priced by reference to commodity futures contracts from major commodity sectors including energy, agriculture, and industrial and precious metals.
Liontrust MA Diversified Real Assets (GB00BRKD9W23) is actively managed and invests in other funds which invest in assets such as infrastructure, commodities and specialist property.
Funk also suggests getting exposure to property globally via real estate investment trusts (Reits) because many of the buildings they invest in have leases with inflation clauses built in. He uses Schroder Global Cities Real Estate (GB00BDD2DQ09) in portfolios he runs.
But Funk argues against making wholesale changes to your investment portfolio because market cycles can change quite quickly.