How to protect your scheme from rising interest rates

In rates, what goes down must come up. We just don’t know when. But what we do know is that rising rates drag the value of fixed rate bonds down.

In rates, what goes down must come up. We just don’t know when. But we do know that rising rates drag the value of fixed rate bonds down.

This happens because a raised interest rate immediately makes an existing bond look poor value against new ones issued against the higher rate.

Many pension fund trustees reading this will feel relaxed and turn over to the next page – that’s because they’ve ticked the interest rate box. They may have done that with a judicious approach to duration and hedging.

If rates rise, the value of their liabilities will decrease more than the value of their fixed income assets. That means the funding position, and its ability to pay pensions, will actually improve. Many schemes will hold long-duration assets due to the benefits they provide to a scheme’s funding position.

For trustees in this position, interest rate rises are things that worry other people, aren’t they?

However, the simple fact is that rising interest rates are harmful to fixed-rate assets.
No matter what the hedging position is, the prospect of losing money is not an attractive one, and that is where two smart ideas come into play.

First, separate interest rate hedging from credit assets.

Hedging out interest rate risk on fixed rate assets using derivatives effectively acts as a shield against the impact of rate rises.

To take an extreme example, the 100-year bond issued by energy company EDF has a duration of 19 years, so a 1 per cent change in yields would decrease the investment’s value by 19 per cent if the interest rate risk is not stripped out.

Buying protection

Once this is done, you can then concentrate on getting the best return from the widest range of credit assets, so the second idea involves greater consideration of ‘floating rate assets’ – the sort of bond security that offers a return floating above the ebb and flow of the rate tide.

Floating rate assets can be found in almost every corner of the world’s credit markets.

Take mortgages for example. Asset-based securities and direct commercial mortgages can offer investors security against underlying assets.

Carefully selected residential mortgage-backed securities and well-structured senior commercial mortgages tend to offer better returns for the same security as corporate bonds, or the same returns for more security. Many of their returns are floating rate.

Seniority and security can also be found in Europe’s leveraged loan market. Sitting just above high-yield bonds in the capital structure, and therefore offering that bit more peace of mind should things go wrong, loans can deliver around 4 per cent on top of the rate at which banks lend to each other.

Private lending to UK companies also offers a floating rate return. This very old market is experiencing a renaissance, as banks retrench in the face of higher borrowing costs.

Here, the banks’ loss is a pension fund’s gain, as good-quality UK companies in the mid-cap and slightly smaller mid-sized spaces are funding themselves directly from pension schemes or through funds designed to do just that.

Such investments are already finding high levels of traction with Britain’s pension funds, who will either invest in floating rate assets individually or via a fund that can seek value across all of them.

Given no one knows when rates may go up, only that they will at some point, it would be sensible to carry on seeking value in bond markets. Schemes, however, will probably want to spend most of their time hunting in floating rate markets.

Bernard Abrahamsen is head of institutional sales and distribution at M&G Investments