INTEREST is the cost associated with the use of other people’s money. The rate of interest is the amount of returns paid to the lender by the borrower. It is mostly determined by the risk-free rate set by governments — monetary policies; inflation rates; supply and demand for loans (capital); and lastly the risk borne by the lender, when they extend credit. The higher the risk, the higher the level of interest charged. The major borrowers are individuals — through mortgages and credit card debts. Businesses borrow money for the purpose of business expansion and working capital support; and governments to operate countries.

The world has experienced mostly low interest rates over the last few years as governments move to spur economic growth after the US and European debt crisis of 2008 and 2011 respectively. Economies have improved unevenly since then, with Europe looking at ways to stimulate theirs as the prospect of deflation looms. Hence, the US, the world’s largest economy has began to reduce their monthly stimulus activity of purchasing USD85B of mortgage securities; thus reducing the demand vs the supply for mortgage securities and pushing up interest rates. This move has impacted the US 10yr Treasury, the benchmark rate used by investors to assess risky investments. The rate increased to 2.70 per cent from 1.73 per cent one year ago and peaked at 3.03 per cent on December 31, 2013. This led to a lower repricing of emerging markets currencies, stock and bonds and other high yield securities.

Generally, already issued fixed coupon bond prices will fall, as new bond investors seek the new higher rate of interest (yield) by paying a lower price for the bond. Equity prices will also be negatively affected as their revenues will decline due to lower spending levels and higher operating costs due to higher interest expense.

Investors should consider the following strategies to protect their portfolios against rising interest rates:

(1.) Analyse your current holdings: Speak to your SSL Wealth Advisor or Financial Planner to determine your optimal asset allocation based on your goals and risk tolerance. Determine the types of bonds and bond-like (preference shares) investments you own, their duration and credit ratings.

(2.) Assign your portfolio to a knowledgeable Bond Manager: Add more convertible and floating rate bonds, floating rates and non-agency mortgages and less plain fixed rate bonds and index bond funds to your portfolios as they suffer the most in a rising interest rate environment.

(3.) Shorten the duration (maturity) of your bonds: Shorter date maturity bond are less sensitive to interest rates increases and lower the probability of losses.

(4.) Bond Laddering: Create a held-to-maturity portfolio of bonds with staggered maturities. These bonds will be redeemed at par, thus reducing price risk, and also presenting the opportunity to invest in new issues at higher interest rates.

(5.) Equities: Invest in the stocks of companies from economy sectors who are able to pass on the increase cost of doing business from increase interest rates such as Consumer Staples and Health Care companies (eg Coca-Cola, Diageo, Procter and Gamble and Wal-Mart Stores). Banks and other financial holding companies such as Berkshire Hathaway also benefit from rising interest rates.

To conclude, interest rate risk is an important risk that every investor faces. With prudent management substantial benefits can be gained.