Hedging interest rates and inflation

Hedging interest rates and inflation

Investors are increasingly searching for investment opportunities of greater than one year that hedge against interest rates and inflation, according to Investec Impala.

Harris Gorre, head of new financial products, said that clients are looking to source investment-grade floating rate notes because they are worried about rising interest rates and investment grade corporate inflation-linkers to alleviate inflation concerns.

However, many corporates have no requirement to issue either floating rate note (FRN) or inflation-linked bonds. “This creates an unnatural shortage in the market, especially in the UK, where gilt futures provide for an imperfect duration hedge,” said Gorre.

There are options available that offer inflation-like returns such as infrastructure, commercial property and private equity but Gorre said these are often illiquid and can be risky.

“One of the reasons defined benefit pension schemes are buying these assets is because there are not enough inflation-linked bonds, which easily offset the risk,” added Gorre.

Insurance companies are heavily long in bonds and have a dearth of attractive opportunities, given the fact that most FRNs are issued by banks in the three to five-year maturity and pay a very low coupon. “This does not address their yield or income requirements,” said Gorre.

The expectation of rates longer than one year has been gradually shifting upwards with the expectation of 3ML over the next 10 years doubling from 1.49% to 3% in 2013, which Gorre noted was a poor year for insurance companies because their investment portfolios lost money. “If they bought a bond when the expectation was 1.5% then they have effectively lost capital value on that bond,” he says.

Gorre expected more innovation around duration and observes one interesting development of closed-end exchange traded funds in the US. “A closed-end ETF offers the value of inflation at maturity and if it takes off in the US then we could see similar innovation in the European market.”