How to Mitigate Interest Rate Risks

Strategies for Limiting Interest Rate Risks

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Interest rates govern how much of a premium borrowers pay to lenders for access to capital. Higher interest rates encourage more borrowing and lower interest rates encourage less borrowing. Central banks use monetary policy tools to influence interest rates and economic growth by adding or removing liquidity from the financial system for corporations to access.

Impact of Interest Rates

Interest rates impact the economy by adding or removing liquidity from the financial system and thereby encouraging or discouraging economic growth. Often times, central banks will lower interest rates to encourage more borrowing to fuel growth and raise interest rates to discourage more borrowing when they feel that the economy is at risk of overheating.

These dynamics can have a big impact on national stock markets and therefore international investors. For example, lower interest rates are often correlated with an increasing stock market. On the one hand, low-interest rates encourage public companies to borrow more to reinvest in growth. On the other hand, low-interest rates can encourage investors themselves to borrow more on margin to buy stock.

Of course, these dynamics are not absolutes by any means. Japan’s economy underwent a so-called "lost decade" despite having very low-interest rates because companies were not comfortable borrowing the money despite the low rates. These companies were already struggling with high debt burdens, making them reluctant to take on more debt to “grow their way” out of the problem.

The advent of quantitative easing and other unconventional monetary policies have made interest rate manipulation less effective as a monetary policy tool when rates are already near zero. While some countries have pursued negative interest rates, these policies haven't been as effective as other monetary policy options that have been deployed since the 2008 financial crisis.

On the other hand, the threat of rising interest rates has demonstrated the potential to significantly move the markets. The so-called Taper Tantrum in 2013 prompted a sharp increase in Treasury yields after the Federal Reserve announced plans to reduce its asset purchases and eventually start increasing interest rates. Regulators have sought to avoid these problems by being transparent with their plans.

The chart below breaks down the risk behind interest rates, illustrating the relationship between interest rates and asset prices.

Mitigating Interest Rate Risk

International investors have many different tools at their disposal to mitigate interest rate risks, ranging from forward contracts to the shifting of bond portfolios to take advantage of the trends. While some of these processes are best suited for institutional investors, individual investors have many options at their disposal to help mitigate the same risks on a smaller scale.

The most popular strategies to protect against rising interest rates include:

  • Buy Interest Rate Futures: Sophisticated investors can purchase futures contracts on government bonds or interest rate futures. These trades enable them to lock-in a certain interest rate and hedge their portfolios.
  • Sell Long-Term Bonds: Many individual investors hedge against rising interest rates by selling bonds, which tend to see their prices fall as yields rise, particularly in bonds with long maturities and low coupon rates.
  • Buy Floating-Rate or High Yield Bonds: Many individual investors also hedge against rising rates by transitioning their bond portfolios from long-term to short-term bonds, like high yield bonds, or floating rate bonds.

The inverse of these strategies can also be used to protect against falling interest rate environments. For example, selling interest rate futures, buying long-term bonds, and selling floating-rate or high-yield bonds could mitigate the risk. Investors also have the option of simply transitioning into equities as well, which tend to do well when interest rates are lowered, provided the economy is still doing well.

And finally, there are some popular alternative methods to mitigating interest rate risk, although they are less direct than the three aforementioned strategies. Precious metals tend to rise in value as interest rates move higher, which means investors can purchase them as a hedge against higher rates.

Equities also tend to outperform during rising interest rate periods, which means it may make sense to transition a portfolio's weight from bonds to equities. In particular, growth stocks tend to do the best when interest rates are on the rise, while dividend stocks become less attractive. The opposite is true when interest rates are on the decline.