A veteran bond investor has revealed how he is preparing his portfolio for the likelihood of rising interest rates in the coming years.
Bryn Jones, who runs the £820m Rathbone Ethical Bond fund and the £90m Rathbone Strategic Bond fund, said he has been buying bonds with a shorter duration to maturity compared to those being acquired by his peer group average.
Bonds with a shorter date to maturity offer protection from interest rate rises, as the chance of the investor suffering a capital loss as the bond's value falls in line with a rate rise is reduced by the fact the bond reaches maturity sooner.
Mr Jones said his view on rates differs from his rivals - he is more expectant of interest rates rising in the near future than are his peers - and so he is taking more action to protect his portfolio from interest rates rises.
Charles Hepworth, investment director at GAM, said generally the market is expecting UK interest rates to rise to 0.5 per cent in March of 2018.
But Mr Jones's said his peers are not positioning for that.
He feels buying bonds with a long date to maturity is a "risk not worth taking" when the market view is that rates will rise within a year.
He was speaking prior to the decision of the Bank of England's Monetary Policy committee voting on 3 August to keep rates at the current level of 0.25 per cent.
Sterling and the yield on UK government bonds both fell in the aftermath of the announcement, as Bank governor Mark Carney cut his forecasts for UK economic growth this year and next.
Mr Jones said Bank of England governor Mark Carney “messed up” by cutting interest rates in the immediate aftermath of the EU referendum vote.
“The economic data was reasonable at that time, and has been reasonable since. The effect has been to weaken the currency and to push up inflation,” he said.
The fund manager said he has been buying floating rate notes (FRNs), and UK mortgage bonds, because interest rates rising doesn’t lead to defaults in the short-term.
Floating rate notes are bonds with an interest rate that moves in line with inflation, rather than being a fixed rate as with most bonds, and because rising inflation is one of the ingredients likely to lead to higher interest rates, FRNs offer protection from rate rises.
"Central banks tend to put interest rates up when the economy is doing well, they only put interest rates up to curb inflation when you have the sort of hyper-inflation that has happened in emerging markets," he said.
"There is no sign of that sort of inflation happening in the UK.
"So an interest rate rise would happen because the Bank of England was confident that the economy was performing well, and there wouldn’t be a lot of mortgage defaults in that environment.”
Mr. Jones said that it is only after a number of interest rate rises have taken place over several years would mortgage defaults begin to rise.
As a result of this view, the UK mortgage bonds Mr Jones has invested in are residential mortgage backed securities (RMBS).
The Rathbone Ethical Bond fund is the top performer from 90 funds in the IA Sterling Corporate Bond sector year to date, and has returned 49 per cent over the past five years, compared with 30 per cent for the sector average.
Advisers are watching the direction of travel for interest rates keenly.
Angela Murfitt, chartered financial planner at Fairstone, told FTAdviser interest rate rises globally will “almost certainly” lead to capital losses for investors.
Ms. Murfitt added: “ The inverse relationship bonds have with interest rates is a challenge since a rise in interest rates will almost certainly lead to significant capital loss for some bond holders.
"Every day we are one day closer to the point where this issue will materialise.
"However markets tend to anticipate and therefore even though there is no material change in these factors, fear of the outcome moves in and can cause prices to shift purely on sentiment."
She added the bond asset class can be significantly segmented within itself, so specific areas are less affected by the interest rate risk.
"Amongst the most important issue is duration since potential capital loss is magnified by the duration of the bonds in question.
"We would be looking for shorter average duration funds to gain some measured return whilst insulating our clients’ portfolios with the lower risk of capital loss this investment brings.”
