The time is ripe for an interest rate hike by the European Central Bank. It is probable that the reference rates will remain stable until the expiry of the Frankfurt institute's extraordinary program for the purchase of securities scheduled for September 2018. But, towards the end of the year, a first tightening could come.
For fixed income investors, rising rates cause the prices of outstanding bonds to fall, and markets usually begin to price in advance of such an event. Jose Garcia-Zarate, associate director of ETF research in Europe, has come up with three strategies for preparing for the squeeze using publicly traded index funds.
STRATEGY 1: REDUCE THE DURATION
The first is to reduce the duration, i.e. the sensitivity of one's portfolio to changes in interest rates. “Let's assume an investment of 10 euros in an ETF (Exchange traded fund, Ed) that spans the entire spectrum of maturities,” explains Garcia-Zarate. “For example, iShares Core EUR Government Bond, Lyxor EuroMTS All -Maturity Investment Grade or Xtrackers Eurozone Government Bond ETFs, all with Analyst rating Gold and an average duration that is now around 7,5 years. If we move 5 euros to ETFs with a 1-3 year maturity, the overall duration drops to 4,65 years and the risk of losses deriving from the fall in security prices is also reduced. At the same time, the benefits of diversification are maintained”.
Duration management strategies require a certain degree of preparation on the part of investors, because it is necessary to monitor economic developments and understand how and when they influence monetary policy decisions.
STRATEGY 2: ELIMINATE THE RISK RISK
The second strategy aims to exclude the risk of a rise in interest rates from the portfolio. The instruments are floating rate bonds (floating-rate notes), therefore with duration equal to zero, or ETFs with coverage of this variable (interest rate hedges).
“In Europe, two such ETFs are currently available, Lyxor Barclays Floating Rate EUR 0-7y and Amundi Floating Rate Euro Corporate 1-3y,” explains Garcia-Zarate. “The first tracks an index of bonds with a maturity of up to seven years; the second between 1 and 3 years. Other differences between the benchmarks underlying the two instruments mean that Lyxor's is more exposed to credit risk, and therefore has potentially higher yields”. Alternatively, iShares Euro Corporate Bond Interest Rate Hedged exposure to a portfolio of corporate securities investment grade and uses a short position in the German Bund as a hedge, to make the duration close to zero.
STRATEGY 3: DO NOTHING
“Investors who use bonds solely to offset equity exposure shouldn't pay too much attention to changes in interest rates,” says the Morningstar researcher. “Instruments such as iShares EUR Aggregate Bond or SPDR EUR Aggregate Bond could be interesting from this point of view”. Both track the Bloomberg Barclays euro aggregate bond index, which is made up of approximately 50-60% government bonds, 10-15% quasi-government bonds, 15-20% corporate bonds and 10-15% bond bonds. covered, all denominated in euro and investment-grade.
SOURCE: Morningstar
