Optimising Liquidity When Interest Rates Are Rising: Three Key Steps

A rising rate environment can be a challenge even for the most sophisticated fixed income investor. And even though treasurers know further rate hikes are on the cards, they may happen more swiftly than some imagine. In this unpredictable environment, an actively managed ultra-short-duration strategy could be the optimal liquidity solution for treasurers.

The potential impact on liquidity management of the current rising rate cycle demands the attention of fixed income investors. Although interest rates in the US have already started to rise from historic lows, more rises are on the cards. What is less certain however, is how quickly these hikes will be enacted. This is making it challenging for treasurers to know what to do with their liquidity.  

The good news is that by studying past rising rate cycles and using dynamic scenario analysis of potential future rate moves, treasurers managing liquidity through this environment can gain valuable insight that can help to inform their next steps. As part of their strategic decision making process, therefore, treasurers may wish to start including a review of the three major rising interest rate cycles seen over the last few decades:

Some key changes happened throughout these times, with an inevitable impact on credit spreads (see Figure 1). 

Fig 1 - Credit spreads over recent rising rate periods  Source: Bloomberg/Barclays, J.P. Morgan Asset Management.

During Period 1, for example, the Fed hiked the fed funds target rate seven times over 12 months, from 3% to 6%. The average increase per hike was over 40 bps. Throughout Period 2, the Fed funds target rate rose six times over 11 months, from a starting level of 4.75% to 6.50% with an average increase per hike of 30 bps. And during Period 3, the Fed raised the fed funds target rate at a more measured pace of 17 times over 24 months from a starting level of 1.00% to 5.25%, moving 25 bps each time.

In Periods 2 and 3, the markets were able to anticipate and price in the tightening of monetary policy. But the 1994 tightening caught markets off guard. Both the fed funds target rate and US Treasury (UST) yields began to move higher – more or less simultaneously. 

One of the burning questions on treasurers’ lips today is which of the previous rising rate cycles will the current period most resemble? Although the Fed is well on the way to policy normalisation, it’s still too soon to say. Nevertheless, historical data from the three periods above can help to pinpoint strategies that tend to outperform in periods of rising rates.  

Armed with this information, treasurers may want to consider the following steps to help them prepare for rising rate cycles now and in the future.

Step 1: Analyse past performance to reveal the trends 

By looking into the past, treasurers can identify trends that are likely to occur again if rates rise – regardless of the environment being different, or the pace of the rate hikes. For example, when rates are rising, previously issued fixed coupon securities typically decrease in value as investors shift to new, higher-yielding bonds. But because bonds with shorter maturities, floating interest rates and/or higher yields should experience less dramatic price declines in a rising rate environment, treasurers can potentially improve the total return of their bond portfolios by shifting to shorter duration and higher-income-generating strategies. 

Here’s how the past performance analysis supports this conclusion.

Step 2: Use sensitivity analysis

Typically, in a rising rate period, a portfolio invested in longer-tenor fixed coupon bonds suffers lower total returns than one invested in shorter-tenor fixed coupon bonds. It is important for treasurers to be aware that there are two components of total return, though: price and income. These can be better understood using sensitivity analysis. 

The four different hypothetical scenarios here are offered for illustrative purposes.

Scenario 1: The parallel shift of the UST yield curve

Take a hypothetical six-month period in which interest rates increase in precisely parallel fashion (a rarity), rising at each point along the Treasury curve by an assumed +50 bps. An investor with a three-year Treasury note at an annualised yield of 2.62% at the beginning of the period would receive an income return of approximately 1.31% (262bps x 6/12 months). 

The investor’s price return would be roughly -1.10%, due to the move higher in rates. Combining the two, the total return would be about 0.21% for the six-month period. Under the same scenario, an investor who purchased a one-year Treasury would see a total return for the period of 1.01%, given the bond’s shorter time to maturity and lower duration. 

Scenario 2: Steepening of the UST yield curve

Where the steepening of the curve is seen (as it was in early 2018), longer bonds rise at a greater magnitude than shorter. Negative returns on bonds with longer durations are thus magnified.

Apply this to the same hypothetical six-month period and the shift in rates becomes more pronounced for longer maturity bonds than for shorter ones.  

Scenarios 3 and 4: Enhancing income via a credit spread

Scenario 3 builds on Scenario 2’s beginning and ending interest rate levels. Overlaying credit spreads on top of those interest rate levels portrays the starting yields on riskier bonds, assuming that credit spreads for each point on the yield curve remain constant over the period. Treasurers will be interested to note that the three-year security’s return went from -108 bps in Scenario 2 to -45 bps in Scenario 3, and the return of the one-year security went from +101 bps to +123 bps. 

Also of interest is that in Scenario 3, credit spreads were unchanged over the period. Spreads can widen if investor demand for these securities declines. When rates are rising, a credit product can underperform Treasuries. Scenario 4 shows the potential impact of a +50 bps spread widening at each point on the yield curve during the period; projected total returns are generally worse than those in Scenario 3. 

Step 3: Protect and optimise your fixed income portfolio 

Another question treasurers will be asking themselves is how can they protect a portfolio of bonds in a period of rising rates? Despite the risks, there are strong arguments for maintaining a core allocation to fixed income in most interest rate environments, as fixed income provides diversification, a steady stream of income and a lower volatility investment over time. Additionally, fixed income portfolios with longer durations have provided higher returns, albeit with greater volatility, over longer time horizons.

However, for investors with shorter investment horizons (especially treasurers with potential near-term cash needs) or those seeking to protect profits realised from longer duration strategies, mitigating potential volatility during the anticipated rising rate environment is a key priority. To that end, treasurers may wish to consider how they can best employ two effective strategies for managing a rising rate environment: shortening duration and increasing income. 

Shortening a portfolio’s weighted average duration

This is arguably the most effective way to protect a portfolio from the impact of rising rates. In traditional fixed income portfolios, this is typically achieved using one or more of the following methods. 

Increasing the interest income component of total return

This not only lowers duration but also provides greater income return, helping to offset declines in price during periods of rising rates. However, this can add risk and fixed income investors must also be aware of spread duration. In addition, when rates start to rise, it is important for treasurers to understand not only where credit spreads are but also where starting yields are, relative to historical levels.

Time to put theory into practice

Given the current rate environment, and the inevitability of future hikes, it could be argued that now is perhaps the most appropriate time for treasurers to be considering actively managed short-term strategies. 

After all, the Fed’s policy of normalisation has gone from measured to more aggressive, and it is possible that coming economic data will see an even more aggressive stance on rate hikes. Yet ongoing trade disputes and a strengthening dollar may persuade the Fed to slow normalisation. In other words, unpredictability reigns.

To help offset any risk, treasurers would do well to start developing a thorough understanding of past market behaviour, as outlined above. Their strategic decision making process should also ideally be guided by a robust scenario analysis of the future possible directions of interest rates, credit spreads and the shape of the yield curve. Critically, however, any evaluation of various investment strategies should be informed by the investor’s short-term cash needs and risk tolerance.