Where is the rise in interest rates good?
With inflation at 40-year highs, the US Federal Reserve raised its target range for the federal funds rate by 25 basis points (bp) and projected six more increases in 2022. Currently, the futures market of federal funds is pricing in an increase of roughly 270 bps this year. That would surpass the 250 basis point hike in 1994. A Deutsche Bank report recently suggested the Fed could raise short-term rates as high as 6%.
Higher interest rates are usually associated with declining asset values. This is especially true in fixed income markets where interest rates and bond values are inversely related and interest rate sensitivity is measured by duration. A similar dynamic applies to equity valuations, although to different degrees depending on the valuation method.
Basically, the value of a company is the present value of its future earnings. Future profits are negatively affected by rising interest rates as they increase the cost of borrowing and drag on net earnings. Also, the present value of these future cash flows decreases when they are discounted at a higher interest rate. However, higher interest rates will act as a headwind for certain hedge fund strategies, three in particular.
1. Commodity Trade Advisors (CTA)
CTAs take long and short positions in commodities, currencies, equity indices and interest rates through the futures market. Because of the inherent leverage built into these instruments, many CTAs only deploy 10% to 20% of their capital, with the balance allocated to short-term fixed income instruments. Rising interest rates will increase your potential returns. In fact, demand for CTA has increased due to its neutral or even negative correlation with the equity and fixed income markets.
CTAs fall into two main categories: medium-term trend and short-term trend, with the vast majority of capital invested in the former. Medium-term trend CTAs hold positions from six weeks to six months, while their short-term counterparts hold them from daily to several weeks.
Along with strong, long-term performance records, the best CTAs are negatively correlated with only long-term benchmarks and, most importantly, are positively skewed. How much positive skew is an important metric because correlations are dynamic and across sectors and strategies often move toward 1.0 during market selloffs. CTAs with a high positive slope tend to be shorter and provide valuable protection against tail risk when everything is declining.
2. Reinsurance
Reinsurance strategies assume insurance companies’ liabilities for property damage to residential and commercial properties primarily caused by hurricanes, earthquakes, wildfires, and other natural disasters. Reinsurers are profitable when the premiums they collect exceed the claims they have to cover: their performance has little correlation with the capital markets.
Regulators require reinsurance funds to hold 100% of their contingent liabilities, usually in escrow or escrow, until the insurance contracts expire. Most reinsurance contracts have terms of one year or less. Reserves are invested in short-term securities, where increases in short-term interest rates improve returns. It’s worth noting that while climate change is real, one-year contracts also give managers the opportunity to incorporate climate change data into their assumptions of expected returns and losses, thus muting any effects on the wallet
Expectations of return on investment in reinsurance have increased dramatically over the past five years. In many cases, premiums have more than doubled, while the risk of loss has increased only slightly. Today, many investors anticipate double-digit returns.
3. Higher Business Turnover Relative Value Fixed Income
Strategies that provide liquidity to complex or less liquid fixed income securities have replaced bank trading desks. Rising interest rates increase volatility in fixed income markets, and higher volatility often leads to higher returns for these trading-oriented strategies. Managers generate most of their returns through alpha and limit market beta by actively hedging both interest rate and credit spread risk. These approaches also have little correlation with capital markets and can provide some risk protection during market sell-offs.
CTAs, reinsurance and short-term relative value fixed income are just a few of the hedge fund strategies that should benefit as short-term rates rise from near 0% to potentially more than 3% This will have two main implications for the hedge fund industry:
- These strategies will increase your market share at the expense of other approaches. The $4 trillion hedge fund industry is ripe. Investors make their allocations after careful evaluation, across strategies and managers, based on which offer the best opportunity to add value to their portfolios. These decisions influence not only new assignments, but also reassignments from one manager to another. The expected return between different managers may vary by only 1% or 2%. So the demand for people helped by the increase in interest rates will grow significantly.
- Large institutional investors are more likely to negotiate a hurdle in performance fees. Downward pressure on hedge fund fees has focused on performance and management fees, as well as performance hurdles and time frames. If short-term rates continue their upward trajectory, more institutional investors will demand a yield hurdle for the carried interest portion of the yield generated by the portfolio’s cash position.
There is a lot of uncertainty about what rising interest rates will mean for the markets and the wider economy. Recession, stagflation and other potentialities cannot be ruled out.
However, while the net effect of rising rates may be negative, it’s worth remembering that some strategies can win.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Donald A. Steinbrugge
