The Bank of England may have decided to keep interest rates on hold at last week’s meeting of the monetary policy committee but many fixed-income managers are taking steps to mitigate an increase in rates, which they expect sooner rather than later.
The MPC’s decision sees the record run of the lowest-ever bank rate held at 0.5 per cent but, with inflation consid- erably above the official 2 per cent a year target and rising, the pressure is on for the BoE to increase rates at some point. Several fixed-income fund managers are already taking steps to prepare their funds for what they see as an inevitable increase.
Skandia head of asset allocation Rupert Watson recently said a gradual change in attitude from the MPC is likely to see a series of rate rises from May and he predicts rates of between 2 and 3 per cent by the end of next year.
Another manager who thinks we are likely to see rates start to increase in May is Henderson Global Investors head of fixed income John Patullo.
He says: “We are pretty concerned about the UK, especially inflation and the interest rate environment. The market is pricing in three interest rate rises. That is possibly a little bit over done but we do expect rates to rise in May.”
Patullo says at this stage in the economic cycle as economies reflate, concerns over inflation come to the fore and the markets start to sell gilts. Patullo says: “So far in 2011, markets are behaving broadly as you would expect at this time in the cycle – a broadly reflating environment.
“Sovereign bonds are selling off as people begin to worry about inflation, while credit markets continue to perform paticularly well, especially at the high-yield end and the leveraged loan end of the market.”
He says gilts are down by 3 per cent so far this year, with investment-grade corporate debt down by 1.5 per cent but high yield is comfortably outperforming both, up by 3 per cent.
“Our funds have performed well in this environment and that is how we remain positioned.”
To take full advantage of the current environment, Patullo says he has changed the self-imposed restriction of a maximum of 40 per cent exposure to high yield in the preference and bond fund.
“It is a bit constraining and, as this is a self-imposed restraint, the decision has been taken to allow this up to 60 per cent. We very much feel that in this default environment and this rising interest rate environment, our unitholders will be better served accordingly.”
LV= Asset Management is also repositioning its fixed-interest funds on the expectation of rate increases. It says it expects current interest rates to remain in place slightly longer and suggests the first rise could be as late as August but it also expects to see increases over the course of the year, with rates ending the year at 1.25 per cent.
Head of fixed interest Michael Wright says: “We have been positioning our funds for an interest rate rise, or series of interest rate rises, since November last year. We have made the tactical decision to avoid the parts of the market most sensitive to rate rises, which has involved selling out of five-year bonds into either cash or one-year gilts and into the longer maturity bonds.
“These bonds are currently yielding around 4.6 per cent and we anticipate that ongoing demand from pension funds will keep these at the current level.
“We believe duration is not the best way to play the market as interest rates rise but instead to position selectively on the gilt curve.”
Axa Investment Management chief investment officer for fixed income Chris Iggo is also warning about the risks associated with medium-duration gilts and says the market is pricing in increases in interest rates for both the UK and the eurozone.
Iggo says: “Our recommendation is to limit exposure to the risk of higher bond yields, either through limiting duration exposure (short-dated bonds), focusing on areas of the bond market where there are still attractive credit spreads – high yield – and by having a large holding of inflation-linked bonds.”