Rising rates and higher inflation: how they impact your portfolio

Inflation jumped unexpectedly in August, with the consumer price index rising to 2.7% on the back of higher clothing prices, transport bills and recreation costs, according to the Office for National Statistics.

Looking ahead, there are other factors that are likely to cause the cost of living to continue to rise. Firstly, the oil price, which stands at a four-year high and has pushed the price of petrol upwards. Secondly, Brexit worries have caused the pound to weaken against other major currencies. Higher inflation could encourage the Bank of England to raise interest rates from 0.75% to 1% later this year.

What does this mean for your investment portfolio?

Rising interest rates and inflation present a huge challenge for bond investors because they erode the fixed income that a bond provides. As their popularity wanes, their prices fall (as there is less demand). This in turn causes yields to rise because they move inverse to prices.

The team behind Elite Rated TwentyFour Corporate Bond and TwentyFour Dynamic Bond funds notes that bond market volatility has returned with a vengeance.  

“After a long period of relative calm, markets are struggling to navigate an increasingly unpredictable geopolitical climate,” a spokesperson said.

2018 has so far shown how bond portfolios can suffer in these conditions: trapped between the capital-eroding effects of rising rates in the UK (and even more so in the US) and mark-to-market misery of volatility.

Swerving the difficulties

One way for investors to swerve the difficulties of a difficult bond market is to use a strategic bond fund. These strategies have grown in popularity over the past decade and allow fund managers to diversify their bond investments across a range of markets and sectors, shifting allocations as they see fit.

Strategic bonds, such as Jupiter Strategic Bond and GAM Star Credit Opportunities, are able to make use of investments like floating rate bonds (which pay a variable – or floating – coupon rate that can be linked to government bond yields) and convertible bonds (fixed income instruments that can be converted to equities) to mitigate some of the challenges associated with traditional bonds.

What about equities?

When bond yields go up, historic evidence indicates that equities rise too, according to Legal & General Investment Management. Looking back at the last four decades, it found 16 periods where US Treasury yields rose sharply. And in 14 of these time periods, the S&P also moved upwards, on average, by more than 7%.

If yields are rising, Legal & General says it’s important to consider the reasons behind this. For example, stronger growth or declining deflation risk normally spells good news for equities. However, this isn’t the case if yields are higher because of hyperinflation worries. Equities can generally cope well with a slow rise, while sharp moves are more problematic.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.