How to protect cautious investors against the threats of normalisation

Sam Liddle of Church House Investment Management, explores how Floating Rate Notes provide a hedge against rising interest rates, as well as a higher return than deposit cash, with full liquidity and low volatility.

What type of investment provides a hedge against rising interest rates, a higher return than deposit cash, with full liquidity and low volatility? The answer is Floating Rate Notes (FRNs), which the Church House fund managers make good use of in their Investment Grade Fixed Interest Fund and Tenax Absolute Return Strategies Fund. In both funds, FRNs represent the largest asset class allocation.

For almost a decade now we have enjoyed an unprecedented period of low interest rates in the UK, Europe and the US. This, together with intervention from Central Banks, has helped the developed economies to recover from the credit crisis and also driven markets up. The US has been the first of these three major economies to focus on debt reduction and a return to normal (if there is such a thing), interest rates. The Bank of England has taken its first step with a rectification of their ‘emergency cut’ before Christmas.

As fund managers, we monitor this position closely and, in order to avoid the risk of permanent loss of capital, we consider various strategies to hedge against the risks that come from a period of sustained increases in interest rates. Furthermore, with an approach to investment that starts with capital preservation, we are always on the lookout for liquid assets that offer low volatility and returns greater than cash; hence the appeal of Floating Rate Notes.

FRNs are debt instruments, typically issued by major banking institutions, supra-nationals (e.g. European Investment Bank) and governments, and, as the name implies, FRNs differ from other fixed income securities by having a variable (floating) coupon rate.

The coupon on a FRN is re-set every quarter to a specified level over the reference rate (e.g. LIBOR). When interest rates rise, LIBOR, in turn, ratchets up and consequently the coupons on FRNs increase. FRNs therefore benefit from rising rates and provide a hedge to monetary policy tightening and, opposed to derivative hedging and structured products, the FRN hedge is built-in.

Gilts and other debt instruments, such as investment grade and high yield corporate bonds, are inversely correlated to interest rate movements fall in value when interest rates rise. For this reason, FRNs make up a significant component of the investment grade bond market and tend to be in demand when interest rates are expected to increase.

The Church House Tenax Absolute Return Strategies Fund aims for positive returns in excess of cash (3 month GBP LIBOR) over rolling twelve-month periods. As well as providing a hedge against rising interest rates; the inclusion of Floating Rate Notes within the Fund exceed the target return objective and moderate the Fund’s volatility. However, they are also fully liquid so when volatility increases in other asset classes, creating mispricing, the fund managers are able to sell FRNs to exploit those opportunities.

After a decade of near zero short-term interest rates in the UK, the direction of travel has changed and the indication from Governor Carney is that rates have started to rise. There are no guarantees that this trend is going to continue but advisers and wealth managers need to consider the possibility and be aware of the implications for their investors. Cautious investors, who typically have a higher allocation to traditional bond assets, are most likely to be adversely impacted by such a scenario and will be most sensitive to increased volatility. Investing in portfolios and funds, which have a strategy to mitigate this, might be a sensible approach for those who do believe we are on the path to interest rate normalisation.If rates now rise faster and further than investors and commentators expect, gilts and corporate bonds will suffer while the c.35% allocation to Floating Rate Notes in the Tenax Absolute Return Strategies Fund and in the Investment Grade Fixed Interest Fund will prosper.

Issued by Church House Investment Management

For professional adviser use only. Please remember that the value of investments and the income you get from them may fall as well as rise and there is no certainty that you will get back the amount of your original investment. Past performance may not be a reliable guide to future performance.

Church House Investment Management is a trading name of Church House Investments Limited, which is authorised and regulated by the Financial Conduct Authority (FRN 190548).