Investors are becoming overly complacent about the impact of higher interest rates, according to Old Mutual’s John Ventre, who has moved into “full risk management mode” within his bond allocation and rotated his equity positions in preparation for the first hike. 
Concerns about higher interest rates in the US and UK have been a persistent headwind over the last year or so, but those fears had been sidelined over recent months as the Greek debt negotiations and huge falls in the Chinese equity market took centre stage.
However, with those two issues (albeit temporarily) swept under the carpet, market attention has once again turned to the future of monetary policy in the US and the UK as both the Federal Reserve and the Bank of England have both dropped their biggest hints yet that they will raise rates over the coming six months – which will be the first hike for around 10 years.
Despite that change to the status quo, a large number of industry experts have calmed fears by stating that a rate hike has been so well telegraphed for bond markets, any rises are likely to be small and incremental and that tighter monetary conditions are a positive for equities as it suggests the underlying economy is healthy.
Nevertheless, Ventre – head of multi-asset at the group and manager of its Spectrum, Voyager and Foundation ranges – warns that investors are becoming overly complacent about interest rate rises, especially as the extremely loose monetary policy has been a major driver of the rally in both bonds and equities since the financial crisis.
Performance of indices since the global financial crisis
Source: FE Analytics
“Are people really aware of the risks they are taking? I don’t think it’s an unreasonable thesis to say ‘no they are not’,” Ventre (pictured) said.
The major reason for that is because Ventre feels investors are stepping into the unknown, given that rates have never stayed at such low levels for such a long period of time.
“I think the potential for a US rate rise is the main risk to markets, as you have to think that the Greece and China-induced volatility as acted as a mirage,” Ventre said.
“The reason I am nervous, which is quite rational, is that we have never seen anything like this before. We have never seen rates rise this late in the economic or market cycle. Normally, a rate rise is confirmation to equity markets that the economy is in solid shape.”
“Of course, you could interpret it like that this time, but I feel the cat is somewhat out of the bag as when you look at the multiples in the US, it doesn’t look like a market which is struggling for good news.”
“For the time being, I think the circumstances warrant caution because after years of extremely loose monetary policy, the punch bowl is being taken away.”
The manager’s main concern, of course, is fixed income, as higher rates are likely to force bond yields higher. In order to protect his investors, Ventre has reduced his duration (or exposure to interest rate risk) to his lowest ever level.
“We are down to full risk management and hedge mode,” he added.
Nevertheless, the manager – who has outperformed his peers over the past five years – is baffled that so many investors are exposed to interest rate risk at the long end of the yield curve.
Performance of Ventre versus peer group composite over 5yrs
Source: FE Analytics
He, like JPM’s Bill Eigen and City Financial’s Mark Harris, warns that the bond market simply isn’t priced correctly and therefore adds that investors could be hit by uncharacteristically large drawdowns from perceived safer funds if they are not vigilant.
“The consensus seems to be that rate rises have been so well talked about, it’s all baked in the cake. However, if you look at the implied market prices, I don’t think that’s true,” he said.
“Ten-year UK gilts currently yield 1.92 per cent and that suggests that if we are going to see rates rise over the next 10 years, there are only going to be four increases. Current bond yields are too low.”
To lower his portfolio duration, Ventre has upped his exposure to direct short-dated bonds and derivatives but investors who have similar concerns may want to choose a fixed income portfolio which concentrates on that area of the market.
One example is the AXA Sterling Credit Short Duration Bond fund, which is headed-up by Nicolas Trindade and carries an ‘A’ rating from Square Mile.
“About 20 per cent of the portfolio matures each year, which gives some protection against any future rises in interest rates, as the manager should be able to re-invest maturing bonds at higher yields,” Square Mile said.
“The fund is perhaps most suitable as a cash substitute for investors who are willing to tolerate a higher level of volatility than cash, but be rewarded with a higher income over time.”
Albeit with far lower drawdowns, the £260m AXA fund has materially underperformed its average peer in the IA Sterling Corporate Bond sector since its launch November 2010 as longer duration assets have flourished.
Performance of fund versus sector and index in 2015
Source: FE Analytics
However, as the graph above shows, the fund has performed strongly this year as government bond yields spiked and the sector has fallen. AXA Sterling Credit Short Duration Bond has a yield of 1.78 per cent and an ongoing charges figure (OCF) of 0.43 per cent.
Many investors may wish to avoid fixed income altogether until yields spike following a correction in the market, but Ventre says that the coming few years are going to be painful for bond holders.
“Unlike in previous cycles, I think it is going to be more of a grinding bear market. People will lose money by stealth rather than through one big correction. The big challenge is though, no one has really experienced a bond bear market and you have to go back to 1994 or the 1980s since it last happened.”
Performance of indices in 1994
Source: FE Analytics
1994’s double sell-off in bonds and equities (as the graph above demonstrates) was caused by an interest rate hike in the US, but many warn the next rate rise could be even worse for fixed income as yields are at much more compressed levels than they were 20 years ago.
The manager says investors also need to be active in terms of their equity exposure in preparation for tighter monetary policy.
Like many fund selectors, Ventre is avoiding mega-cap defensive equities (or ‘bond proxies’, as many have now been called) in favour of UK and US small and mid-caps, which tend to be more exposed to their domestic economies.
One large cap portfolio he is particularly bullish on, however, is Alastair Mundy’s Investec UK Special Situations fund, which has been through a tough run of late largely as a result of the manager’s particularly contrarian style.
The £1.3bn fund has underperformed against both the IA UK All Companies sector and the FTSE All Share over two years due to Mundy’s bias towards bombed-out companies, his short on the S&P 500 and his high weighting to cash.
However, with a portfolio which is geared to lowly valued stocks and companies that tend to be more economically sensitive (he counts Shell, BP, Lloyds and RBS as top 10 holdings), Ventre says Mundy is well positioned for a rising rate environment.
Performance of fund versus sector and index under Mundy
Source: FE Analytics
As the graph above shows, Investec UK Special Situations also has a long-term track record of outperformance.
According to FE Analytics, it has comfortably outperformed its highly competitive sector since Mundy took charge in August 2002 with returns of 231.70 per cent and has beaten its benchmark by more than 40 percentage points in the process.
Investec UK Special Situations, which yields 2.3 per cent, has an OCF of 0.85 per cent.
