Hedging Interest rate risk

[Walrus]

Not sure that this is the right place but it is more liberal than the other board .

I've been wondering about interest rate risk on my HYP and if there is an efficient way of hedging it for the private investor and which funds products I shoukd be looking at

Looking at my portfolio I see a lot of downside risk shoukd interest rates rise, both in terms of companies carrying large amounts of debt and also the likely flight of income investors moving from high yield to cash/bonds as rates rise.

I think it would be remiss of me not to explore this avenue. I'm not interested in derivative type instruments but looking for investments that are likely to outperform on a higher interest rate risk environment. I'm not convinced by Banks here as a hedge.

[langley59]

I think we are a long way from income investors turning away from equities to bonds in this country. This may be happening in the US where you can get over 3% on Treasuries which is higher than the overall stock market yield, but in the UK you can't.

[colin]

This may be happening in the US where you can get over 3% on Treasuries which is higher than the overall stock market yield, but in the UK you can't.

It's easy enough to buy US bonds through ETFs.

[Gengulphus]

I've been wondering about interest rate risk on my HYP and if there is an efficient way of hedging it for the private investor and which funds products I shoukd be looking at

Looking at my portfolio I see a lot of downside risk shoukd interest rates rise, both in terms of companies carrying large amounts of debt and also the likely flight of income investors moving from high yield to cash/bonds as rates rise.

I think it would be remiss of me not to explore this avenue. I'm not interested in derivative type instruments but looking for investments that are likely to outperform on a higher interest rate risk environment. I'm not convinced by Banks here as a hedge.

I wouldn't be convinced by banks as a hedge either - they mainly make their profits on the difference between the interest rates they pay and the interest rates they charge. When interest rates rise, both will tend to go up accordingly, and I'd guess the difference between them is likely to remain roughly the same (essentially being driven by competition between the banks). That will be perturbed upwards by savings products on which they've offered fixed rates (and locked customers into thoroughly), and downwards by loans they've made at fixed rates, but I doubt the net effect of those is all that major.

I'm not certain there really is a non-derivative hedge for rising interest rates - I would look more towards reducing my exposure to interest rates than finding a hedge. One particular point is that large companies with a lot of debt have often borrowed the money by issuing corporate bonds at fixed interest rates and so the interest bills on a lot of their debt are not immediately affected by interest rate rises. So there isn't necessarily all that big an immediate rise in their interest bills. When each bond matures, however, their interest bill is likely to rise if they have to roll it over into newly-issued debt.

The net result is that if I were worried about a company's required interest payments rising due to general interest rate rises, I wouldn't look so much at the level of debt as at its maturity profile (out to as far as I reckoned the general trend of interest rates is foreseeable) and at how it is changing. A high and rising level of debt would be distinctly worrying, but a high level of debt that the company is paying off much less so: in the right circumstances, it might even be paying it off more rapidly than just dealing with it maturing, by buying and cancelling its own bonds - and if those bonds were issued when interest rates were generally low and bought back when they're generally higher, it might even be buying them back below par and so making an overall profit.

Gengulphus

[langley59]

This may be happening in the US where you can get over 3% on Treasuries which is higher than the overall stock market yield, but in the UK you can't.

It's easy enough to buy US bonds through ETFs.

Maybe so but that then introduces exchange rate risk.

[colin]

What puzzles me is that according to some financial journalists both equity and bond markets fall as interest rates rise, so where does the money flow to? currency?

[colin]

Maybe so but that then introduces exchange rate risk.

it's easy enough to buy currency hedged bond ETFs

[dealtn]

What puzzles me is that according to some financial journalists both equity and bond markets fall as interest rates rise, so where does the money flow to? currency?

You own an equity. You sell an equity. Someone else buys that equity from you. The "money" stays invested in the same asset class, it is now simply owned by someone else. The total "money" may have a marginally lower worth as the marginal seller (you) has slightly changed the marginal price downwards.

Should you decide to invest your (recently acquired from the equity sale) "money" in a different asset class the same thing happens. You are a marginal buyer buying from a marginal seller, and may have an equally small affect on the prices in the new asset class. The "money" invested in that asset class isn't particularly altered.

The presence or absence of marginal buyers and sellers affect the prices offered by market makers (or other market determinants), and this will affect the value of the "money" in each asset class.

[colin]

Thanks dealtn,
but i can't say that explained anything to me, though it did prompt some thoughts, what's a 'marginal' buyer as opposed to any other kind of buyer?

[dealtn]

Thanks dealtn,
... what's a 'marginal' buyer as opposed to any other kind of buyer?

The marginal buyer (or seller) is the person next buying (or selling) and setting the effective price at which all holders of the instrument are being valued at.

Imagine a simple example of say an equity market consisting of a single equity, of which there are say 1 million shares currently valued at 100p. The entire market is valued at £1,000,000. Or in other language there is £1mio "money" invested in equities.

A single marginal seller, for whatever reason wishes to exit the market, and sells his 1,000 shares and finds the buyer at 99p, then £999 exchanges hands, ignoring costs, but as there is both a buyer and seller at that price the £999 stays in equities. With the "price" now (just) 99p, not 100p the entire value of the equity market is now not £1,000,000 but £990,000, a difference of £10,000.

No money left the market, although the original holder has swapped a paper asset for an increase in his bank balance of £999, yet £10,000 has "left the market".

Scale this up to something approximating the real world and you get silly headlines and comments about billions being wiped off the market, or billions leaving the market etc., when the reality is somewhat different.

Because falls in prices tend to be more noteworthy than rises, and typically are, or at least appear to be bigger or associated with increased volatility, you get a disproportionate amount of media noise about wealth destruction etc.

As humans we succumb to emotional rather than factual or rational interpretations unfortunately.

[Gengulphus]

... what's a 'marginal' buyer as opposed to any other kind of buyer?

The marginal buyer (or seller) is the person next buying (or selling) and setting the effective price at which all holders of the instrument are being valued at.

Which basically means that at the moment that you're a buyer or seller on the stockmarket, you're always a marginal one, and so the word "marginal" doesn't add to a simple "buyer" or "seller" at all. And what you wrote might be a bit clearer if without a couple of the "marginal"s, as:

"Should you decide to invest your (recently acquired from the equity sale) "money" in a different asset class the same thing happens. You are a marginal buyer buying from a marginal seller, and may have an equally small affect on the prices in the new asset class. The "money" invested in that asset class isn't particularly altered.

The presence or absence of marginal buyers and sellers affect the prices offered by market makers (or other market determinants), and this will affect the value of the "money" in each asset class."

Not meant as a major criticism - just as a suggestion that might help to clarify what you wrote a bit.

Gengulphus

[Walrus]

I've been wondering about interest rate risk on my HYP and if there is an efficient way of hedging it for the private investor and which funds products I shoukd be looking at

Looking at my portfolio I see a lot of downside risk shoukd interest rates rise, both in terms of companies carrying large amounts of debt and also the likely flight of income investors moving from high yield to cash/bonds as rates rise.

I think it would be remiss of me not to explore this avenue. I'm not interested in derivative type instruments but looking for investments that are likely to outperform on a higher interest rate risk environment. I'm not convinced by Banks here as a hedge.

I wouldn't be convinced by banks as a hedge either - they mainly make their profits on the difference between the interest rates they pay and the interest rates they charge. When interest rates rise, both will tend to go up accordingly, and I'd guess the difference between them is likely to remain roughly the same (essentially being driven by competition between the banks). That will be perturbed upwards by savings products on which they've offered fixed rates (and locked customers into thoroughly), and downwards by loans they've made at fixed rates, but I doubt the net effect of those is all that major.

I'm not certain there really is a non-derivative hedge for rising interest rates - I would look more towards reducing my exposure to interest rates than finding a hedge. One particular point is that large companies with a lot of debt have often borrowed the money by issuing corporate bonds at fixed interest rates and so the interest bills on a lot of their debt are not immediately affected by interest rate rises. So there isn't necessarily all that big an immediate rise in their interest bills. When each bond matures, however, their interest bill is likely to rise if they have to roll it over into newly-issued debt.

The net result is that if I were worried about a company's required interest payments rising due to general interest rate rises, I wouldn't look so much at the level of debt as at its maturity profile (out to as far as I reckoned the general trend of interest rates is foreseeable) and at how it is changing. A high and rising level of debt would be distinctly worrying, but a high level of debt that the company is paying off much less so: in the right circumstances, it might even be paying it off more rapidly than just dealing with it maturing, by buying and cancelling its own bonds - and if those bonds were issued when interest rates were generally low and bought back when they're generally higher, it might even be buying them back below par and so making an overall profit.

Gengulphus

Thanks for this, going to do some drilling into accounts, for profiles. From experience it's difficult to tell if notes are floating or not from the accounts. FYI the trigger for my question was what I considered a surprising comment in the Marston trading guidance citing higher interest costs. It wasn't something I was expecting and I'm rather overweight in my value portfolio

[colin]

Ok thanks,
now I understand what you are describing as something like this, a big pension fund needs to sell some US Treasuries, those who might otherwise have been happy to buy the Treasuries at yesterdays prices are reluctant to do so because they see interest rate rises looming on the horizon, therefore they will only buy at a price lower than yesterdays price , so the value of the Treasuries falls in order to satisfy a potential buyer, without the money necessarily going elsewhere. But then i am still thinking that the buyer needs to have something in mind that could be bought which would provide a higher return than treasuries at yesterdays price and whatever that 'something' is cannot be equities. In other words the way i am seeing it is that the value of Treasuries has fallen because they have to compete with another asset which is???

[colin]

Might be of interest (pun intended)

https://citywire.co.uk/money/bonds-sell-off-boosts-banks-as-brexit-hopes-lift-pound/a1163828?re=58787&ea=154288&utm_source=BulkEmail_Money_Daily_Summary&utm_medium=BulkEmail_Money_Daily_Summary&utm_campaign=BulkEmail_Money_Daily_Summary

[dealtn]

... always ...

Yes I accept I was overly guilty of jargon to the wrong audience, the combination of having an economics and markets background I guess.

Just as a "suggestion", and not a major "criticism" I would avoid using the word in bold as it sets a very restricting standard.

You can buy, and indeed sell, on the market without being the marginal buyer so it doesn't "always" hold. Leaving orders, on the platform, not with a broker, for instance, or in an auction, or through delivery against a derivatives contract as other examples. Admittedly that would apply to few retail users of the market and not at all applicable to the subject of this thread.

[Alaric]

Looking at my portfolio I see a lot of downside risk shoukd interest rates rise, both in terms of companies carrying large amounts of debt and also the likely flight of income investors moving from high yield to cash/bonds as rates rise.

You might look at Companies with large defined benefit pension schemes. The value placed on future pension liabilities will be lower at higher interest rates and if payments to support the pension fund are invested in bonds, higher interest rates will increase returns.

[colin]

I wouldn't be convinced by banks as a hedge either - they mainly make their profits on the difference between the interest rates they pay and the interest rates they charge.

I am only guessing but i think it would depend on why interest rates are rising, if it is because wages are rising faster than inflation then we may well see more workers in the UK buying houses which would mean increased business for banks.
I came across an online article which asked if US banks were a good hedge against rising US rates about 18 months ago, the authors thought that at that time it was too late as US banks prices had already risen substantially, I have no idea if that is the case for UK banks as i do not buy individual company shares.