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Managing interest rate risk

Movements in interest rates affect a range of asset classes through various channels and to different extents. Photo: shutterstock.com

Movements in interest rates affect a range of asset classes through various channels and to different extents. Photo: shutterstock.com

Interest rate risk is one of the key risks investors should keep under close watch when assessing the exposures of their investment portfolio. It is a well-known fact, though sometimes little appreciated, that bond prices can experience significant downward movements when interest rates rise. Interest rate risk is therefore the possibility of loss in the value of an investment due to a change in the level of interest rates.

Movements in interest rates affect a range of asset classes through various channels and to different extents. However, the inverse relationship highlighted above is most directly related to the price of fixed-rate bonds and can negatively affect the value of all such instruments including high quality bonds as well as government bonds.

The price sensitivity of a bond, in other words, the degree to which the price of a bond drops as interest rates increase, depends primarily on the maturity and the coupon rate of the security. Take, for instance, one bond that matures in one year and another bond that matures in 10 years. As interest rates increase, holders of one-year bonds are able to reinvest into higher yielding bonds much quicker than holders of 10-year bonds. Therefore, the price sensitivity to movements in interest rates is higher for long-term bonds than for short-term bonds.

Secondly, the impact of interest rates on two bonds with similar characteristics (such as maturity, credit quality and yield-to-maturity) but different coupon rates also varies. When interest rates start to rise, the value of the bond with a lower coupon rate is expected to decrease more than the value of the bond with a higher coupon rate. Hence, in general, long-term bonds with low coupon rates have higher interest rate risk than short-term bonds with high coupon rates.

Assessing interest rate risk is therefore understanding the sensitivity of the value of the portfolio of investment holdings to movements in interest rates and analysing the likelihood of an increase in rates.

Given the downward movement in market interest rates experienced over the last few years, prices of bonds have increased significantly as their yield-to-maturity moved lower. This in turn has enticed bond issuers to refinance their borrowings at lower coupon rates and, generally, with longer maturity periods.

Bond investors can manage their exposure to interest rate risk through various strategies

Due to these mechanics, it is particularly important for investors to assess the interest rate risk of their portfolio in a low-interest rate and low-yield environment. It is even more relevant in today’s market environment as we are seeing positive growth momentum building in major economies which will likely translate to higher inflation rates.

Moreover, central banks are expected to react to these developments by tightening monetary conditions using various policy tools, including increasing key interest rates.

Bond investors can manage their exposure to interest rate risk through various strategies. The simplest route would be to increase the portfolio allocation to cash and term deposits and/or to shorten the maturity profile of the portfolio by switching from long-term bonds into short-term bonds.

Investors may also consider investing part of their bond allocation in floating-rate bonds. This would allow a portion of their bond holdings to reset regularly at higher coupon rates as market interest rates increase, while limiting the potential adverse movement in the price of such securities.

For more sophisticated investors, hedging interest rate risk can also be achieved by entering into derivative instruments. The most common strategies would be to introduce interest rate swaps and bond futures in the portfolio. With an interest rate swap, an investor enters into a bilateral agreement with a swap counterparty to exchange a stream of payments at a predetermined fixed rate and notional amount and to receive payments on a floating rate basis. The resulting effect of combining an interest rate swap with a portfolio of fixed-rate bonds is essentially that of converting the fixed coupon payments to floating thereby hedging the interest rate risk of the portfolio.

Bond futures, on the other hand, are exchange-traded contracts that allow the holder to buy or sell bonds (such as German Bunds or US Treasuries) in the future, say three months from now, at a predetermined price. By selling bond futures, the investor would be able to offset losses on bond positions due to rising yields with gains on the short future positions thereby limiting or neutralising the impact of a rising yield environment on the bond portfolio.

The timing of implementing a hedge against upward movements in interest rates is very difficult to determine, even for the most seasoned investors. However, the selection of the hedging strategy to be adopted requires careful assessment of all the risks involved and expert evaluation to ensure that the desired outcome is achieved.

Matthias Busuttil is senior portfolio and investment manager at Curmi and Partners Ltd.

www.curmiandpartners.com

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.

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