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The funds that can protect you from rising interest rates

Raising interest rates is back on the agenda this year, despite Bank of England governor Mark Carney’s attempts to lower expectations.

In a recent FE Trustnet poll, however, 71 per cent of the 1,493 respondents said they were not preparing their portfolio for such a scenario.

Whitechurch Securities’ Gavin Haynes says that while he thinks the most likely scenario will be lower interest rates for longer, it is wise for investors to add an element of protection in their portfolios should interest rates rise unexpectedly.

“There is little inflationary pressure in the medium-term,” he said.

“We do think even though people talk about interest rates going up 100 per cent, up to 1 per cent, even that is low by historical standards.”

“But interest rates and the economic environment still remain unpredictable, so it’s prudent to have some protection in case interest rates do go up.”

The UK economy is pulling itself out of recession far faster than experts thought, highlighted by the fact that the UK unemployment rate fell sharply to 7.1 per cent in December – close to the key 7 per cent level where the Bank of England said it would consider raising interest rates.

Although Carney has insisted he does not want interest rates to rise for some time yet, he may have no choice if the economy keeps heating up.

Since markets have rallied so strongly over the last 12 months, Haynes says equities have much further to fall should interest rates spike, which is why he prefers to use certain areas of fixed income to protect against interest rate risk.

“Equities as a whole, if we do see a significant increase [in interest rates] quicker than the markets expect, that would cause a correction,” he warned.

He says companies that are highly leveraged and cyclical in nature will be harder hit, which is why he is avoiding the utilities sector.

Hargreaves Lansdown’s Adrian Lowcock (pictured) agrees and says protection against rising interest rates is the territory of bond managers.

“Most equity managers don’t have a particularly strong view,” he said.

“On the whole, fund managers were well prepared for QE to cease and although unemployment in the UK has fallen faster than expected, Mark Carney has managed expectations on interest rates pretty well.”

Haynes says the best way to protect against rising interest rates, and perhaps even net inflation-beating gains when rates do head north, is to hold cash.

“Cash is king if interest rates rise,” he said.

However, for the moment Haynes and Lowcock tip several fixed interest funds in the sovereign, high yield and strategic bond sectors and one multi-asset portfolio that can help shield investors from the effects of rising interest rates.

Sovereign and investment grade bonds

Haynes likes the 1.5bn Ignis Absolute Return Government Bond fund as insulation against rising rates. FE data shows the fund has held up in recent times when markets have shivered.

As FE Trustnet highlighted in a recent article. the fund posted its best relative performance in the second quarter of 2013, when equity and fixed income assets took a sharp fall.

The fund uses both long and short positions in safe haven government bond markets and currencies to hedge against the risk of rising bond yields, a strategy that has paid off over the last 12 months.

It made 6.69 per cent over that period, diverging from its benchmark, EONIA, which lost 3.13 per cent. The IMA Targeted Absolute Return sector made 4.45 per cent over this time.

Performance of fund vs sector and index over 1yr

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The fund requires a minimum investment of 1,000 and has ongoing charges of 1.55 per cent.

“The market seems to be predicting the Bank of England base rate will hit 3 per cent in late 2016, with the 10-year gilt yield around 4.25 per cent,” Lowcock said. “Snowden argues you need some ‘heroic’ assumptions to believe rates will get much higher than this.”

Kames Investment Grade Bond has beaten the IMA Sterling Corporate Bond sector over the past one, three and five years. It made 70.33 per cent over the latter period, compared with 54.83 per cent from the average fund.

The fund requires a minimum investment of 500 and has ongoing charges of 1.31 per cent.

High yield bonds

Haynes says that high yield bonds offer a better way to protect against rising interest rates than other areas of the fixed income asset class.

“High yield tends to be a less interest rate-sensitive area of the market. It is more affected by default rates than interest rate movements,” he said.

The AXA fund, managed by Carl Whitbeck. has beaten the IMA Global Bonds sector over the last one and three years and continued to deliver positive returns over the shorter term while the sector has lost money.

The fund has made 18.9 per cent since launch in April 2010 while the sector gained 9.96 per cent, according to FE Analytics.

Performance of fund vs sector since launch

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The fund is available via selected platforms.

The 1.6bn Kames High Yield Bond fund, which sits in the IMA Sterling High Yield sector, has a solid long-term track record, beating its peers over five and 10 years. The fund has fallen behind over the shorter term, returning 5 per cent over the last 12 months while the sector gained 5.99 per cent.

It has performed broadly in line with its peers over the last three years.

Performance of fund vs sector and index over 3yrs

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The fund, managed by Philip Milburn and Claire McGuckin. favours industrials, with 57.66 per cent invested in high-yield debt in the sector, followed by telecommunications, media and technology.

It requires a minimum investment of 500 and has ongoing charges of 1.3 per cent.

Strategic bonds

Another fund Haynes thinks will fare well in a rising interest rate-environment is the five crown-rated Jupiter Strategic Bond portfolio, run by FE Alpha Manager Ariel Bezalel.

“The duration on the fund is two years. The short duration should make it more resistant to the effect of interest rate rises,” he said.

The fund has beaten the iBoxx Sterling Non-Gilts All Maturities index and the IMA Sterling Strategic Bond sector over the last one, three and five years.

The fund has made 103.83 per cent over five years, nearly double the returns of its benchmark. The sector gained 63.45 per cent over the period.

Performance of fund vs sector and index over 5yrs

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Jupiter Strategic Bond has been more volatile than the sector and index over that period, however, with an annualised volatility score of 6.68 per cent. The sector and index both had scores of roughly 5.6 per cent.

The fund requires a minimum investment of 500 and has ongoing charges of just 1.49 per cent. It is yielding 4.8 per cent.

Flexible Investment

Lowcock also likes the 2.3bn Troy Trojan fund, which is able to invest across all asset classes. The fund tends to be cautious, which is in large part why manager Sebastian Lyon has lagged behind the market of late.

“[Lyon] is concerned about the long-term effects of QE and believes that it will drive inflation and interest rates higher in the longer term,” Lowcock said. “He has therefore been positioned in gold and gold equities, interest rate-linked bonds and so on.”

“His defensive position hurt the fund in 2013 and for the first time in years he actually lost money. While we doubt this will be repeated, his defensive style is likely to hamper performance if markets continue to rise.”

The fund is now fourth quartile over one, three and five years, but it is worth noting that it is one of the only funds in the IMA universe that didn’t lose money in 2008 when the FTSE All Share fell nearly 30 per cent.

The fund was able to repeat its role as a capital protector in 2011, gaining 8.52 per cent while the market lost 8.73 per cent.

The fund is soft closed but can still be accessed via platforms for slightly higher charges.

Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.