Interest rates are now at normal levels and this makes for a new investment environment. If there is one good thing to come out of inflation, it is the normalisation of interest rates. The changes are considerable. The leap in the interest rate on German 10-year government bonds from the abnormally negative level of around -0.5% to the current level of over 2% is a major change. At the same time, the US interest rates have risen to 3.5% in just one year. This new "normal" interest rate environment also creates a new investment environment.
Recent years
We have just left behind exceptional boom years, not so much in the economy but in securities investments. Low and negative interest rates created an investment environment in which all securities reached record levels. The word "bubble" is too vague, "inflated prices" is probably a more appropriate term.
For a prolonged period of time, fixed income investments generated windfall returns as interest rates fell and the value of securities rose. Similarly, any use of debt leverage made sense, because it allowed investors to increase returns. In many illiquid asset classes, such as private equity, infrastructure and real estate, the right amount of debt increases returns. Now, at the time of the transition upheaval in 2022 and 2023, the situation has changed.
The new investment environment
The new normal investment environment is based on normal interest rates. Normal is not a precise way of expressing this, but it reflects a situation where interest rates are not abnormally low and yet not high enough to smother all economic activity.
From an institutional investor's perspective, the new investment environment gives rise to at least the following observations:
1. Lower cumulative return for the transition period
The rise in interest rates that has taken place to date will eat into cumulative returns for some time to come. If the rise in interest rates is of a one-off nature, improved interest yield will compensate for reduced returns due to higher rates. The subsequent effects of the transition will emerge when we look at fixed income cumulative returns for period of few years.
2.
Debt structures bring surprises
De
bt-leveraged instruments may harbour surprises. Prime examples of this are some regional banks in the United States, which made losses when interest rates rose. The losses did not come to public attention until 9 months later. Hence, we may well see similar surprises arising from other investment instruments and structures in private markets this year and the next. It will be interesting to see how successfully funds have been prepared for the rise in interest rates in terms of financing and hedging.
3. Fixed income investments generate returns
The current yield on fixed income investments is of interest to investors. While the prevailing view used to be that fixed income investments failed to generate sufficient returns, now they do. Consequently, they can be added to the investment portfolio.
4. Portfolio protection
Now safe, risk-free fixed income investments also offer a degree of protection. If stock markets fall, interest rates typically come down at the same time. As a result, risk-free fixed income investments potentially offset the risks of equity investments, thereby reducing the overall volatility of the portfolio.
5. Value promises suffer
When interest rates rise, the current value of innovations and development projects tend to fall. Most likely, the new investment environment will complicate venture capital and related investment activities, at least in the short term. The new environment favours more immediate cash flows and value investing.
6. Persistence of the strategic asset allocation
Faced with this new situation, investors are compelled to rethink their portfolio structures. The traditional long-term investor has relied on a progressively evolving strategic allocation that has guaranteed the best expected return/risk ratio. In the new circumstances, everyone will have to ponder whether the higher interest rates entail changes in thinking. If the weight of government bonds has been reduced to zero, now is an opportunity to increase their share. By contrast, if you already have them in your portfolio, no changes are called for. Having weathered the downturn, the portfolio is based on long-term expectations, with a limited role for market timing. This is the case for many pension investors, as other factors can play a greater role in changing portfolio structures than the interest rate levels.
Conclusions
The new normal interest rate levels create a new investment environment. Investors are required to make bigger or smaller adjustments, depending on the changes made in the previous years. However, the crisis and the current situation have shown that many institutional investors have opted for a portfolio structure in which rising interest rates is one of the foreseen scenarios, and, therefore, there is no rush to make changes. Market timing contributes less to success than the expected returns generated by strategic long-term weighting. Many investors have increased their exposure to illiquid assets, and their success will be measured in the course of this transition. However, higher interest rates are likely increase expectations for the future as the burden of the change in rates recedes.
The writer is VER's CEO Timo Löyttyniemi.
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