Unravelling the interest rate thread: minimising risk and enhancing returns

Martina Farrugia is a risk analyst at BOV Asset Management Limited

What is Interest Rate Risk and why is it important?

In today’s economic conditions, investors need to be aware of the impact that interest rates can have on their portfolios. Interest rates can be used as costs to borrowers, as payments received to lenders and/or savers (received on deposit accounts) as a means of compensation. Furthermore, interest rates are also used as a monetary policy tool to control a country’s economic activity.

Interest Rate Risk refers to the probability of an asset’s value changing due to adverse fluctuations in interest rates. Borrowers and lenders become uncertain on the amount of interest they are required to pay and receive respectively due to such changes. Furthermore, interest rate fluctuations affect cash flow activities for businesses and/or credit institutions. For example, rising interest rates disincentivize people to borrow money as it becomes more costly to do so.

According to the BOV Asset Management’s sixth Investment Sentiment Index, Maltese investors showed that they prefer investing in local securities mainly related to the government, property and pension plans. If interest rates rise (fall), the prices of bonds on the market will decrease (increase). Thus, bond investors, especially those holding bonds for long maturities, are susceptible to this risk.

What factors cause interest rates to change?

Governments make use of Open Market Operations (OMO) as a monetary policy tool, which involves buying or selling more of their securities (fixed income) as a means of controlling the level of cash raised for banks to be able to give out loans to consumers. Whether governments decide to engage in contractionary or expansionary monetary policy will affect the level of money supply and thus, influence how the interest rates will move.

The current inflation rate in the European economy is still high. On 27^th July 2023, ECB have announced a raise in the interest rates by 25 basis points to control the level of inflation, which was in effect as from 2^nd August 2023. A higher interest rate will decrease the purchasing power of consumers and so, lenders will expect a higher compensation for the risk of counterparties defaulting on their payment.

What can be done to mitigate this risk?

• Diversification involves investors making sure that their assets are varied by investing in several different asset types (e.g., bonds, equities, ETFs, real estate, commodities etc.), industries, or countries. If a loss is made on a particular investment, the entire portfolio will not be affected as diversification will limit the exposure to the affected assets. However, diversification is to be executed with caution as too much diversification can lead to higher costs for the portfolio. It also becomes harder to make investment decisions as investors must keep up to date with current affairs in various sectors.

• Hedging strategies are used to protect investors from unfavorable interest rate movements by investing in financial derivative instruments:
• Forward Rate Agreements (FRAs)

FRAs are contracts involving two parties who agree on a fixed interest rate to be used at pre-determined future date. Despite the movements of the current interest rate at maturity, both parties will exercise the contract at the pre-determined rate. FRAs are a zero-sum game, i.e., one party will be at a loss whilst the other party will be at a gain, depending on the direction which the interest rate moves.

1. Futures

Future contracts work very similarly to FRAs. FRAs are traded over the counter (OTC), contracts are negotiated privately and are customized according to each party’s needs. Whilst futures are traded on a futures exchange (marketplace) and are standardized (non-negotiable).

1. Options

Option contracts act as insurance offering option holders the right but not the obligation to benefit from a change in interest, at a premium price. These contracts take the form of call options, (which give the contract holder the right to gain from an increase in interest rates by exercising a pre-determined interest rate at a pre-determined date) or put options (which give the contract holder the right to gain from a decrease in interest rates by exercising a pre-determined interest rate at a pre-determined date).

1. Swaps

Interest rate swaps are agreements between two parties are obliged to exchange (swap) fixed-rate interest payments for floating-rate payments over a determined period. Both parties will benefit from a better rate than that offered by banks. There is an intermediary bank/broker holding a fee for executing the swap.

• Stress Testing analyses consists of forecasting hypothetical scenarios through computer simulations to determine whether the company can withstand an economic disaster – in this case, unfavorable interest rates movements.
• Yield Curves can be used as an indicator on how interest rates are likely to move in the future. Depending on the slope of the yield curve, portfolio managers adjust their portfolio to protect themselves from future adverse movements.
• Bond Duration measures how sensitive bond prices are given a change in interest rates. By purchasing bonds with lower durations for short-term securities limits the amount of interest rate risk embedded in those bonds.

It is important that investors are aware of this risk and are prepared to take preliminary action to limit their downside risk, especially on securities sensitive to interest rate fluctuations. By understanding interest rate risk investors can make better investment decisions for their portfolio. Those deciding to invest in hedging strategies should have a high level of knowledge and should use them with caution and they also come with their own level of risk.