The temptation of higher interest rates

The temptation of higher interest rates

One of the most common questions that has come up in recent years amongst our community is why one should bother investing in bonds at all with such low interest rates? A fair question that we have endeavoured to tackle on many an occasion. What is relatively new, are questions around why one would take on the risk of the equity market now that they can achieve a 'high' interest rate on an FSCS protected deposit account offered by their local bank. How things can change very quickly. The chart below highlights the recent interest rate rises in the UK marketplace using the 10-year government bond yield. Although this is probably the mostly commonly referenced government bond yield, interest rate rises have occurred across the yield curve in short, intermediated and longer dated space.

Why sticking to the plan is often the best course of action?

• The equity risk premium is an expected incremental return from the ownership of stocks and shares over and above the risk-free rate (in other words the stock market offers an additional return over and above the interest rate we could get for free by taking no risk - usually investors look to the UK gilt or index-linked gilt yield as a reasonable proxy for this hypothetical rate). If the risk-free rate goes up, then so do the expected absolute returns for the other risk premiums – e.g. equities, property, value (relatively undervalued companies), size (smaller companies), credit, term etc.
• Investors would do well not to forget about inflation. Locking into a nominal return of 3% or more for the next 5-years sounds great on paper relative to recent times, but the market has a priced expectation of inflation over that time period which has been rising. The 5-year inflation-linked gilt yield currently sits at around -1%² and whilst this is materially higher than a couple of years ago it still represents a purchasing power loss. Put differently, the difference between the nominal yield (3%) and the real yield (-1%) can be thought of as a proxy for the market’s expectation of inflation over that time period (3-[-1]=4% per year). After inflation, the expected real return from the gilt market is a purchasing power loss of around 1%, which is much lower than a reasonable long-term assumption from a balanced portfolio of bonds and equities.
• Interest rate movements are notoriously difficult to forecast because markets are very good at pricing information. Interest rate movements are dominated by the release of new information which is, by definition, random. What happens if interest rates rise to 4, 5, 6 or 7% over the next few years? Those that are locked in at 3% are now missing out on the new, more favourable, market interest rate. Second guessing markets is a dangerous game to play, what do you do at the end of the five years, lock in again or go back to your previous solution?
• The longer the time period, the greater the chance of a positive experience in an equity/bond portfolio. For example, in the US market, which is the market with the longest track record of robust data, equities beat one-month treasury bills (cash) roughly half of the time on a daily basis, 2/3 times on an annual basis and 8/10 times over 5-years³. Patience is key!
• If you are lucky enough to work with a top financial adviser, your portfolio has been carefully selected based on your risk profile. Deviating from this implies either a change in your risk tolerance (your ability to stomach market risks such as falls in your portfolio value), risk capacity (how much risk you can financially afford to take) or risk need (the risk you need to take on to achieve your goals) – one suspects these have not changed materially, although never say never.
• It is important to consider this decision from the perspective of your overall financial plan, which has a multidecade horizon. If this is not to match a specific 5-year liability, leaving the portfolio invested aligns the solution with the financial plan. A shorter-term fixed income instrument does not provide a match to the longer term liabilities that are considered in your broader financial plan. At the end of the 5-year period, we are then left with the decision of what to do next, which in itself is a market timing call (a challenge which few, if any, possess the ability to achieve successfully).

Sources:

1. BBC News (2007) Northern Rock gets bank bail out. http://news.bbc.co.uk/1/hi/business/6994099.stm

2. Bank of England (2022) Real yield curve. https://www.bankofengland.co.uk/statistics/yield-curves

3. Ken French Data Library (2022). https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_factors.html