How to position your portfolio for the coming base rate hike – Investment Comment

Hamlet wasn’t talking about the next move for interest rates when he said, “if it be not now, yet it will come – the readiness is all.” But the advice is sound.

 

Although today’s quarterly inflation report may reveal some clues, we still don’t know when the first hike in UK base rates will come. But one thing is for sure – they will not stay at today’s 300-year low for ever. And when the moment comes, investors had better be prepared.

 

The smart money is on a November hike, because big moves like this tend to happen in months when the inflation report is published – when the members of the Bank of England’s Monetary Policy Committee have the most information at their fingertips.

 

Both Mark Carney, at the Bank, and Janet Yellen, his counterpart at the Federal Reserve in Washington, have made it clear that higher rates are on their way. They are doing all they can to prepare us for the inevitable without actually committing themselves to a timescale.

 

Britain looks like it will be first out of the blocks, thanks to the blistering performance of the UK economy this year. But America will not be far behind, if the annualised 4 per cent growth rate in second quarter is any guide.

 

If the first hike does come in November, investors only have three months to prepare their portfolios. For many, this will be a new experience, because interest rates have been broadly on a downward trajectory for more than 30 years now (see graph). There are plenty of younger investors who have never known anything other than a base rate of 0.5 per cent.

 

So what should savers and investors do? The first point to make is that even when rates do start to rise, they will do so gradually and less quickly than in previous economic cycles. That’s because no one is quite sure how well the economy will cope with higher borrowing costs. The Bank will proceed with caution, and will be ready to take its foot off the brake if necessary. That means no one needs to do anything too drastic. 

 

But there are some obvious winners and losers from rising rates. Cash will become a more attractive home for savings. That is good news for the army of “reluctant investors” who dipped their toes into the rising stock market recently, despite an instinctive preference for cash.

 

Rising rates will also make a variable rate deposit account more attractive as a home for cash. This is likely to please those people for whom a “return of” (rather than a “return on”) their capital is the primary investment concern.

 

The main loser from rising rates will be fixed income investments like bonds. That’s because, as the name suggests, the income from a bond (known as the coupon) is fixed, and so too is the capital amount that is paid back to an investor when the bond matures. As rates rise, these fixed elements look less interesting, so the price of the bond usually falls in order to increase the yield and attract buyers. The only way to avoid this capital loss is to hold a bond until it matures.

 

Different types of bond behave differently in an environment of rising rates. For example, a 30-year bond is more sensitive to changes in interest rates than one maturing after two years, because there is longer for the change to have an impact. If you believe interest rates are going up, then you should shift your fixed income investments into shorter-dated bonds.

 

High-yield bonds are also less affected by rising rates than lower-yielding government or investment grade corporate bonds. There are two reasons for this. One is simply that their higher yield provides more of a cushion against rising base rates. The second is the fact that high-yield bonds behave more like shares than bonds – they respond well to an improving economy, because the risk of a company failing to honour its commitments to bondholders is obviously lower in a more buoyant economic environment.

 

I hesitate to recommend high-yield bonds at the moment, however, because their prices have already been pushed to stretched levels by income-hungry investors. Instead, a safer option for most fixed income investors is a strategic bond fund, because it can shift between different types of bond as the fund managers see opportunities. Two of these all-terrain bonds funds currently on our Select List are the Henderson Strategic Bond Fund and the Fidelity Strategic Bond Fund.

 

Within equities, likely winners from a rising rate environment are companies that are heavy users of commodities (the prices of which tend to fall as interest rates rise). Cyclical sectors like technology might also benefit from the strengthening economic backdrop.

 

Areas of the stock market that probably won’t do so well are stocks like utilities, which investors have come to see as a substitute for bonds. These will look relatively unattractive as returns improve elsewhere. It’s pretty much the same story with property companies. The equity market can often perform quite well in the early stages of an interest rate upswing. That’s because investors focus on the reason for the rate rise – an improving economy – and take higher borrowing costs in their stride.

 

The stocks of smaller and mid-sized companies often do well in such an environment, and have performed well in recent years (see graph). Two funds on our Select List that are active in this part of the market are the Old Mutual UK Smaller Companies Fund, and the Royal London UK Mid-Cap Growth Fund. One other asset that investors might want to have second thoughts about is gold. When interest rates are close to zero, there is no opportunity cost in holding a metal paying no income. But it becomes more of a luxury to tie your money up in something providing no yield when rates are on the rise.

 

And of course, the biggest losers of all when rate go up are borrowers. So avoid investing in heavily-indebted companies – and fix your mortgage.