Back in 2014, Mark Carney warned that UK interest rates will rise “sooner than markets currently expect.” Wind the clock forward three years and rates have remained unchanged, with the exception being that 0.25% cut in the wake of the Brexit vote. Carney’s call earned him a number of unflattering nicknames from the ‘boy who cried wolf’ to the ‘unreliable boyfriend’. But now, more than ten years since the last UK rate rise, it seems an increase could be on the cards.
This shouldn’t come as too much of a surprise to anyone. We’ve always known that ultra-loose monetary policy can’t carry on forever – interest rates would need to rise eventually and bond buying in the form of quantitative easing tapered back. The bigger question, however, is whether the nudge upwards is largely a symbolic one, or whether this spells the beginning of more rate rises to come? Moreover, what does this mean for fund investors?
Equities vs bonds
Bonds have been popular investments since the dark days of the financial crisis because bonds pay a set level of income, which is appealing in times of uncertainty. However, rising rates tend to spell difficulty for bonds - that’s because the value of bonds fall when interest rates rise. If you find this counterintuitive, consider the following: You invest £1,000 into a 10-year bond that pays 2%. Now let’s say rates on these bonds go up to 3% and you want to sell your bond investment at its face value of £1,000. Why would any investor pay face value for your bond when they could invest the same amount in a new 10-year bond and earn 3%? So it follows that the bond’s value will go down to offset its lower interest rate. That’s why the yield and the price on a bond move in opposite directions - as soon as the yield goes up, the price falls.
Equities tend to do better than bonds when rates start rising because the conditions that lead to higher rates, such as an acceleration in economic growth, also help fuel stock markets. That’s why a little bit of the right type of inflation indicative of improved economic growth is good for the stock market. But bear in mind that there are marked differences between high inflation, steadily increasing inflation and a genuine inflation shock. The last mentioned would be bad news for equities and most financial assets. With inflation recently hitting a five-year high of 3% - the Bank of England is getting worried and rising inflation is a primary consideration when it comes to the future path of interest rates.
Fund pick: Fidelity Strategic Bond Fund
Why invest in a bond fund if interest rates spell bad news for bonds? For the simple reason that even in an environment of rising rates a bond fund still has an important diversification role to play in a well-balanced portfolio. It is however important to have the flexibility and freedom to invest in a mixture of the right type of bonds - a strategic bond fund can do this. Ian Spreadbury, manager of the Fidelity Strategic Bond Fund is a veteran fixed income investor and it’s worth noting that he’s not too concerned about rising inflation. In fact, Spreadbury believes there are longer-term, structural factors which should keep UK inflation in check - ranging from an aging population supressing economic activity to rising inequality and low wages driven by factors such as the so-called ‘Gig economy’ and falling unionisation.
Small caps over large caps
It is important to remember that the UK stock market is very international, so rates here are less influential than they might be in other countries. As for investments, beneficiaries of rising rates might be small and mid cap stocks because these are more influenced by the domestic economy than larger stocks. And, if the economy is expanding investors will start to favour smaller companies, which tend to have a more domestic focus.
Fund pick: Old Mutual Smaller Companies Fund
One fund which can provide a good way of tapping into this theme is the Old Mutual Smaller Companies Fund, managed by Dan Nickols. Dan Nickols got his first taste of fund management when he began working on the Albert E Sharp Smaller Companies fund back in 1997. Twenty years later and Nickols is still delivering consistently good returns for his investors.
He points out that about 22 analysts follow each company on the FTSE 100 large-cap index, while only three follow the average UK smaller company. Less coverage means that the manager has a higher chance of finding a gem which others have missed or misunderstood.
Defensive over cyclical
The higher bond prices we’ve seen in the wake of the financial crisis also applies to those so-called ‘bond proxy’ shares – stable dividend-payers in defensive sectors. Much like bonds, these companies have been favoured for their ‘port in the storm’ characteristics given the clouds of uncertainty. But rising rates could see the defensive parts of the market fall out of favour while spelling good news for investors that are exposed to cyclical sectors of the economy. In particular, financial stocks stand to do well as they profit from wider lending spreads when interest rates rise.
Fund pick: Fidelity Special Situations
With many investors holding tight to defensive stocks, contrarian investors have been attracted to those parts of the market that don’t fit into this box and consequently have been oversold like banks and commodity and oil stocks. Both sectors feature heavily in the portfolios of seasoned contrarian investor Alex Wright of the Fidelity Special Situations Fund. Wright took the helm of the fund in 2014 and, like his predecessors Anthony Bolton and Sanjeev Shah, focuses on finding unloved companies entering a period of positive change. More than a quarter of the fund is currently in financials, including Citigroup and Lloyds Banking Group, both of which stand to benefit if interest rates rise.
The value of investments and the income from them can go down as well as up, so you may not get back what you invest. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment. Reference to specific securities or funds should not be construed as a recommendation to buy or sell these securities or funds and is included for the purposes of illustration only. Please be aware that the price of bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer’s ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. This information does not constitute investment advice and should not be used as the basis for any investment decision nor should it be treated as a recommendation for any investment. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. Fidelity Personal Investing does not give personal recommendations. If you are unsure about the suitability of an investment, you should speak to an authorised financial adviser.