While For Purpose organisations could be forgiven for focusing on the impact of rate changes to their typically high fixed income allocation of their portfolio, the reality is that nearly every asset class has sensitivity to interest rate risk. It is important for organisations to identify, measure and manage this risk within their entire portfolio.
Equity and interest rate risk
It might surprise some investors to know that equities have sensitivity to interest rates albeit lower than that of fixed income. Generally speaking, in a rising rate environment, companies that have a high level of short-term floating rate debt will suffer more than companies that have longer-term fixed rate debt. Additionally, industry specific characteristics also determine the degree of interest rate sensitivity. Consider, for example, the utility industry. Equity returns for utilities (or any other industry/company that is highly regulated/pays a high dividend) are generated in large part via dividend payments; higher interest rates diminish the value of the dividends and therefore performance of the equity suffers, which in turn increases the total portfolio risk. Financials, Listed real estate and infrastructure securities also illustrate a much more marked link with interest rates (as per utilities) than other listed equities.
Just as rising U.S. interest rates may diminish equity returns, domestic interest rate policy may act as a support for Australia and New Zealand’s high yielding market. At the same time, U.S. equities are a dominant force in global markets and any negative sentiment could flow through to global markets, this region included. As introduced above, diverging global interest rate policies pose a challenging environment for investors – there are global headwinds as well as domestic rate tailwinds that need to be balanced.
Currency and interest rate risk
A significant influence on currency fluctuations is the direction of interest rates in the home currency relative to foreign currency. Investors seek to maximise return and therefore are drawn to a higher yielding economy and therefore currency (increasing demand for that currency). An increasing gap in interest rates will, ceteris paribus, lead to a strengthening of the higher yielding currency.
This demand for the interest rate gap or ‘carry’ leads to demand for the higher yielding currency. Either increasing or maintaining its value. The Australian dollar until recent times remained strong despite most commentators noting it was overvalued. This was because cash and bond rates were materially greater than those in the rest of the developed world. Therefore investors were buying higher yielding Australian debt, shares and cash creating demand for the Australian dollar. However, while the US looks to increase rates and there is still the potential for Australia to reduce rates, the interest rate gap is getting squeezed. This means lower demand for the Australian dollar and this is partly responsible for recent falls in the Australian dollar.
Interest rates therefore influence the return and thus success or otherwise of your overseas equity exposure, your strategic (and tactical) hedge ratio and also your domestic stock portfolios. This last point comes from the knowledge that with an increasingly global economy the majority of large companies have earnings or costs from overseas. Therefore domestic investors stand to benefit from the foreign currency exposure embedded in Australian companies with foreign earnings as the Australian dollar falls.
Managing interest rate volatility through total portfolio management
The examples noted above demonstrate that portfolios typically have interest rate sensitivity that is far greater than what would be expected based solely on the portfolio’s allocation to fixed income. So how do you manage this higher rate sensitivity? There are several interest rate hedging approaches available, however, the optimal mix and choice of strategies is influenced by many factors, including:
- Risk and return objectives: risk and return objectives are the single largest drivers of asset allocation, and asset allocation directly influences the degree of interest rate exposure, which in turn influences which hedging strategies are most effective.
- Which type of rate risk is a concern? Some assets are more sensitive to changes in inflation rates while other assets are more heavily influenced by the change in real interest rates. The sum of which is nominal interest rates.
- Time period of concern: the shorter the time period of concern the fewer hedging strategy options are available given costs and timeframes for implementation.
- Resource constraints: weaker analytical capabilities can limit the understanding of interest rate exposures and therefore limit the effectiveness of an implemented hedging strategy.
- Level of dynamic portfolio management: wider dynamic portfolio management capabilities provide more flexibility to control interest rate risk which leads to greater accuracy and lower costs (through more efficient implementation) through time.
The main take-away is to be cognisant that your portfolio has far more interest rate sensitivity than purely that contained within your fixed income allocation. Material movements in interest rates will have knock on effects on your equities (Financials, Utilities, Listed Property and Infrastructure), currency and unlisted property exposures (to name just a few). There are ways in which this risk can be managed which can be either long or short term is nature, depending on the timescale of the perceived risk. The more flexibility the greater number of solutions that are available and the greater the ability to manage the exposure, either wanted or unwanted.