Pension lifestyling fund investors – a subset of gilt investors, these investors are particularly at risk as they will probably never have made an active choice to invest in bonds. As these investors approach their stated retirement date, they are automatically shifted from equities into long dated government bonds. The idea is to hedge annuity rates, which move in line with bond yields. Of course, since the pension freedoms were introduced, very few people now buy an annuity. But these lifestyling programmes, potentially set in train 20 to 30 years ago, are still robotically moving people into gilt funds nonetheless. These lifestyling funds have lost on average 11.6% so far this year (source: AJ Bell, FE total return to 12th October 2021). Any falls sustained in the value of these funds should be offset by rising annuity rates. But then, that’s not much use if you’re not buying an annuity.
Corporate bonds – Unlike gilts, corporate bonds (both investment grade and high yield) carry a higher interest rate, which helps cushion the impact of price falls emanating from fears of tighter monetary policy. They also tend to be shorter dated, which means they are less sensitive to interest rate rises. Being loans to companies rather than governments, they also experience some upward pressure on prices from an improving economy, because the accompanying earnings growth should make it easier for companies to service their debt. In a rising interest rate scenario, these ‘riskier’ bond funds should therefore fare better than ‘safer’ gilt funds, but they still might see negative returns.
Gold investors – higher interest rates aren’t good for gold because it pays no income. That’s much less of an issue when rates are close to zero, and so the opportunity cost of holding an asset with no yield is virtually nil. As interest rates rise, that cost becomes heavier to bear, and cash and bonds become more attractive as safe havens. It’s interest rates in the US which are more important to the gold price than in the UK however. The gold price peaked at over $2,000 an ounce last summer, and has now fallen back to around $1,750, as market optimism has lessened demand for safe havens.
Moneymarket funds – these cash like funds saw £1.6 billion of inflows in August, which is more than they see in most years. Most of that can probably be accounted for by cautious multi-asset funds fleeing bonds, and in the short term we can probably expect to see more money heading into moneymarket funds. Rising interest rates should lead to higher yields in the sector, but like cash, the ascent is likely to be painfully slow, so, it’s going to take a number of rate hikes before these funds offer a reasonable rate of return, particularly when you take charges and inflation into account.
Absolute return funds – rising interest rates are a double edged sword for absolute return funds. These funds tend to hold large sums of cash to offset derivative positions, and so higher rates will feed through into more interest flowing through into returns. However, the target return for many funds is based on LIBOR, so rising interest rates will mean many absolute return funds have a higher hurdle to clear to beat their benchmarks, and potentially collect the performance fees which are common in the sector.
