Funds to protect and profit from higher-for-longer interest rates

The decision by the Bank of England’s Monetary Policy Committee (MPC) to raise interest rates could hardly be described as a surprise. The increase unveiled following its November meeting – from 3.75% to 4% – had been widely predicted. 

But the messaging from the Bank did take some economists aback – several MPC members made it very clear they expected more rate rises to come. And that should be food for thought as investors review their portfolios in the run-up to the end of the year and beyond.

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The truth is that no one can predict exactly where rates are headed. So much is uncertain, above all, what will happen in the Middle East where the Iran conflict has sent energy prices soaring and given rise to the additional inflation that the MPC now feels obliged to confront. Still, right now, interest rates look set to be heading higher than was expected at the beginning of the year, before the US and Israel decided to attack Iran, and those higher rates are likely to last longer than expected too.

Moreover, it is not only the UK that is facing higher-for-longer rates. With inflation in the eurozone at a three-year high, the European Central Bank is widely expected to increase rates again at its final meeting of the year next month, following a 0.25 percentage point hike in September. The US Federal Reserve is also tightening monetary policy, with an increase expected in December, and further rises predicted for next year. In Japan, rates are already at their highest level for 30 years.

Against this backdrop, investors need to think about how their portfolios are exposed to rising interest rates – and to consider whether changes are necessary.

Impact on equities and bonds

The impact of higher rates on equities may be felt in several different ways. Companies with borrowings will now have to pay more to service their debt, squeezing their profit margins. Slower consumer spending, as mortgage costs rise, may hit consumer-facing businesses. Firms where investors hope growth will accelerate over the medium to longer term, including technology companies, can suffer because the value of their future earnings today is reduced by higher rates.

More generally, equities look less attractive when the potential returns from safer assets rise. In particular, interest rate rises typically drive up the yield on bonds, as lenders to governments and companies charge more for their money.

That said, the impact of higher rates on the bond market will also be mixed. Corporate bonds, issued by companies, become riskier when these businesses face increased pressure on their finances. Less creditworthy companies may face particular scrutiny in a higher rate environment.

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Tom Bigley, a fund analyst at interactive investor, suggests two strategies for navigating these choppy waters. “Equity income can provide sustainable income and long-term growth through financially resilient companies,” he suggests. “Strategic bond holdings can capture higher yields while actively managing duration and credit risk.”

Income in favour

Looking at equities first, the advantage of an income-oriented approach is that dividends can support total returns, with companies capable of raising their payouts helping investors to protect their purchasing power. Such companies also tend to have strong cash flows, resilient balance sheets and good pricing power, all of which are especially valuable when higher interest rates squeeze margins.

In this context, Bigley is a fan of the Fidelity Global Dividend W Acc (B7GJPN7) fund. “It takes a relatively cautious approach, focusing on companies with resilient cash flows and sustainable dividends rather than simply targeting high-yielding stocks,” he explains. “It could be a core global equity holding with a defensive income discipline, offering participation in long-term equity growth alongside the potential for more resilient income and lower volatility than the broader global equity market.”

At Winterflood Research, Emma Bird, head of the investment trust research team, also makes the case for an equity income focus. “Value-oriented funds have generally outperformed more growth-focused peers over the past five years, and we would expect this trend to continue if interest rates remain elevated,” she says.

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In which case, Bird picks out the UK-focused Lowland Ord (LSE:LWI) Investment Company. “It offers core, value-oriented exposure to UK equities and benefits from the significant experience of its managers as well as the broader expertise of Janus Henderson,” she says. “The fund’s current discount of 9% remains one of the widest in the 16-strong peer group despite having one of the best net asset value performance records over the last one, three and five years – we think there is scope for a re-rating.”

Looking further afield, equity income plays in the US could also be a good option, Bird adds. “BlackRock American Income Trust Ord (LSE:BRAI)'s focus on value stocks should leave it less exposed to the valuation pressures associated with higher discount rates than growth-oriented peers, while its broad diversification reduces reliance on a small number of mega-cap technology companies,” she says.

Bird also picks out North American Income Trust Ord (LSE:NAIT), which she explains “focuses on high-quality, cash-generative businesses with sustainable dividends and the potential for long-term dividend growth”.

Flexible mandates

As for the bond market, the value of a strategic bond fund, Bigley explains, is that “managers can adjust duration, credit exposure and sector allocation as macro conditions change”. For example, managers can favour shorter duration bonds – those due for repayment sooner – at times when interest rate risk is elevated.

“Jupiter Strategic Bond I Inc (B544HM3) fund is led by highly experienced managers Ariel Bezalel and Harry Richards, who can invest across government bonds, investment-grade and high-yield credit, and actively alter the portfolio’s  interest-rate sensitivity,” Bigley suggests. “This flexibility is particularly useful when the direction of inflation, growth and interest rates remains uncertain.”

Alternatively, Bird likes CVC Income & Growth GBP (LSE:CVCG), which owns a diversified portfolio of sub-investment grade debt instruments, primarily issued by larger European companies. “The fund benefits from the significant resources of the wider CVC network, via access to a substantial number of deal opportunities and considerable in-house expertise across a range of industries,” Bird explains.

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Many fund managers agree with these analyses. At Lowland, the investment trust tipped by Bird, co-manager Laura Foll says the key is to remain flexible and nimble. “You need to ask why we’re in a higher-for-longer interest rate environment,” she argues.

“If it’s because commodity prices are driving inflation higher, the current reason, this will push you towards companies producing commodities. This is why we’ve seen holdings like BP (LSE:BP.) and Shell (LSE:SHEL) perform so well this year. If it’s because economic growth is strong, as it is in the US, the stocks that benefit will likely be more cyclical with exposure to the US. We hold Hill & Smith (LSE:HILS), for example, which is a galvanising and infrastructure products business that generates most of its profits in North America.”

Of course, the consensus view is not always the right one. “The market is pricing in higher-for-longer but is that necessarily what we’ll see?”, asks Liam O’Donnell, a bond fund manager at Artemis. “We agree that interest rate hikes are likely in the UK, for instance, but struggle to see the Bank of England delivering almost five hikes over the next 12 months to contain inflation, which is what the market is pricing in.”

Still, at the least, most investors will feel safer in high-quality, resilient assets – and that may mean shifting away from market indices heavily weighted towards companies which represent a big bet on the future. “Any company that heavily relies on debt funding has just seen their business become harder to run,” says Alex Illingworth, manager of the Goshawk Global Balanced UCITS ETF GBP (LSE:ROES), of the Bank of England rate hike. “So, companies with pricing power, lack of leverage and in areas of growth are the best places to look.”

The alternative approach

Adjusting your equity and bond investments isn’t the only way to manage your exposure to higher interest rates. Real assets can also provide diversification and resilience against economic shocks, including higher inflation. Returns from alternative investments such as commodities and infrastructure tend to depend on different factors to those that drive equity and bond market.

For example, commodities can benefit directly from rising energy, metals and agricultural prices, while infrastructure businesses may be protected by regulated or contractual revenues that are linked to inflation.

“WisdomTree Enhanced Cmdty ETF - USD Acc GBP (LSE:WCOB) provides diversified exposure across major commodity markets, including energy, industrial and precious metals and agriculture,” says Bigley. “It uses an optimised approach to selecting and rolling commodity futures rather than simply tracking the nearest futures contracts.

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“FTF ClearBridge Global Infras Inc WAcc (BMF7D55) fund provides exposure to listed infrastructure businesses such as utilities, transport and energy infrastructure,” he adds. “Many of these businesses benefit from relatively predictable cash flows, regulated pricing or contractual revenues, while also offering an income stream.”