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 on their loans. Higher interest rates encourage less borrowing, and lower interest rates encourage more borrowing.

Central banks use monetary policy tools to control interest rates and growth by adding or removing liquidity from the financial system for banks to access.

Learn how central banks control interest rates to spur lending and help people borrow and spend.

Key Takeaways

  • Central banks may lower interest rates to boost lending and fuel growth. They raise rates to reduce lending when the economy is at risk of growing too quickly.
  • You can purchase futures contracts on bonds or interest rate futures. This lets you lock in your interest rate.
  • Many people hedge against rising interest rates by selling bonds. Bond prices often fall as yields rise.
  • You can hedge against rising rates by switching your bond portfolio from long-term to short-term bonds.

What Do Interest Rates Affect?

Interest rates impact an economy by adding or removing liquidity from the financial system. When central banks adjust rates, they affect growth. Central banks lower interest rates to get firms and people to borrow and banks to lend. They also raise rates to reduce lending when they feel that the economy is growing too rapidly.

These dynamics can have an impact on global stock markets. This is because rate changes usually cause people to move from bonds to stocks or stocks to bonds. They move to stocks because businesses borrow more when rates are low to fund expansions or research. With lower rates, people might use more debt to fund their investments. When rates rise, many firms tend to reduce how much they borrow because it costs them more.

Interest rates are usually tied to decisions made by a country's central bank. A central bank's ability to adjust rates and use other actions to pressure an economy is called monetary policy.

The European Central Bank was among the first to introduce negative rates. It states the evidence shows that the policy boosts the economy and can be used as an inflationary adjustment tool.

Monetary Policy

Central banks began to use quantitative easing after the financial crises. This is a method of slowly increasing the supply of money in an economy to lower interest rates. In the U.S., interest rates have been near zero for over a decade. Since rates are so low, monetary policies such as easing have not worked like they used to.

When policies change, a key factor in the market is how people feel the change will affect their assets. This is called investor sentiment. There are many cases where the threat of rising interest rates created movement in the markets.

Central bank policy doesn't always have the effect the bank wants. From 1991 to 2001, Japan experienced a decade where its economy had very low growth. It experienced a real estate market collapse, causing people to hold onto their money. This caused deflation, where money gains value instead of assets, and people wait for lower prices to spend money. The central bank dropped interest rates to very low levels, but firms and spenders refused to play along and held their money.

The "Taper Tantrum" (named by the media) in 2013 prompted a sharp increase in Treasury yields when a bond selling panic caused prices to decrease.

In 2013, the Federal Reserve had announced plans to reduce its asset purchases and eventually start increasing interest rates at some point in the future. This announcement caused bondholders to think that bonds were going to collapse. They began selling off all of their bonds—the Fed hadn't even taken action yet, only mentioning that they would do something. Since that time, regulators have sought to avoid causing panics by being more transparent with their plans while limiting broadcasting what they might do in the future.

Around 2014, some countries began using negative interest rates to create spending and borrowing. The policy is being closely watched by economists worldwide. So far, investors appear to be moving to longer-term securities under negative rates. Large account owners seem to become less interested in holding their funds because they might be charged to do so.

Interest Rate Risks

The most significant interest rate risks for international investors are:

  • Central banks might change interest rates to affect inflation.
  • Lower interest rates lower asset prices and value, while higher rates cause higher prices and value.
  • They might anticipate value changes and flood into other assets, depending on the central bank's actions.
  • Investor panic can cause wild market fluctuations, in turn affecting other assets.

This chart breaks down the relationship between interest rates and asset prices.

Buy and Sell Based on Interest Rates

International investors have many tools that help them reduce interest rate risks. The tools range from forward contracts to shifting bond portfolios to make use of trends. While some of these methods are best for institutional investors, retail investors have many options to help reduce the same risks on a smaller scale.

The most popular strategies for protecting against rising interest rates include (keeping in mind that as rates go up, bond prices go down; as prices go down, yields go up):

  • Buy interest rate futures: You can purchase futures contracts on government bonds or interest rate futures. These trades enable you to lock in a certain interest rate and hedge your portfolio.
  • Sell long-term bonds: Many people hedge against rising interest rates by selling bonds. Bond prices tend to fall as yields rise, particularly in bonds with long maturities and low coupon rates.
  • Buy floating rate or high yield bonds: Many people hedge against rising rates by changing their bond portfolios from long-term to short-term bonds. Some examples of these are high yield bonds or floating rate bonds.

To protect against declining interest rates, you could use the opposite of those strategies:

  • Sell interest rate futures: Again, you lock in an interest rate and hedge against declining rates.
  • Buy long-term bonds: As rates decline, bond prices fall. Their yields rise, so you can benefit from increasing coupon payments.
  • Sell floating rate or high yield bonds: Moving from high-yield, short-term, and floating rate bonds can help you reduce the losses that can occur when bond yields are rising.

Other Methods That Reduce Interest Rate Risk

There are some other methods you can use to reduce interest rate risk. They are less direct than using bonds because they involve precious metals. Precious metal values tend to rise as interest rates move higher, which means investors can purchase them as a hedge against higher rates (before rates begin rising).

Certain kinds of equity also tend to do well during periods of rising interest rates. It may make sense to shift a portfolio's weight from bonds to equities. In particular, stocks issued by banks, insurance, and payroll processing firms tend to do better when interest rates are on the rise. Growth stocks tend not to do as well during periods when rates are rising because it costs more to borrow money.

If you invest internationally, you can lower your interest rate risks by preparing your portfolio for the occasions when it does happen in the countries you're invested in. Ensure you have enough liquid assets to shift your portfolio to assets that hedge the risks. Become familiar with the central banks of the countries you're invested in and their schedules so that you can be ready to move your assets around.

You can also reduce the amount of risk you take on by having a balanced portfolio to hedge interest rate risk without moving assets around. A mix of metals, bonds, stocks, and funds can help your portfolio continue growing while some of your assets aren't.