The recent turbulence in the banking system should have reminded us that misconceptions of risk exposure or failed risk assessments cannot be afforded. Inadequate risk and liquidity management practices of Silicon Valley Bank (“SVB”) contributed to its demise, causing widespread market volatility and anxiety among global investors. It is generally accepted that the collapse of this US lender could have been avoided had repercussions of the Federal Reserve’s tightening monetary policy and liquidity deadlock scenarios been promptly accounted for in investment decisions.

As in the case of SVB, interest rate hikes can be the source of unfavorable developments, some of which may prove materially detrimental. The purpose of this article is to shed light on such unfavorable scenarios for fund portfolios, across asset classes, investment strategies and sectoral concentration. The article is meant to be of a general nature and although it tries to capture most asset classes and investment strategies, it does take into account aggressive investment strategies, such as speculative trading or short-selling strategies implemented by hedge funds, which in any case can be favored in situations like this.

Below, five plus one (5+1) ways in which interest rate hikes could negatively impact fund portfolios are analyzed, based on the recent turmoil in the banking system:

1. Drop in Market Prices and Lower Valuations 

Depending on the sector, an increase in interest rates may have a significant impact on portfolio prices. Interest rates play a crucial role in equity valuations and price-to-earnings (P/E) ratios as they are a determining factor for discount rates. As interest rates rise, discount rates also increase, which results in a lower present value of future cash flows and earnings. The same applies to the price of bonds as the increase in yields can usually shift investors’ attention to newly-issued bonds yielding higher overall returns. Existing bonds offering lower yields will unavoidably incur a negative adjustment in their market prices in order to offer more attractive profit margins to potential buyers.

The prices of real assets, such as real estate, can be negatively impacted from lower demand due to the higher cost of financing. The same can be said for freight rates for consumer cargos, which may decrease as consumer spending power is distorted.

Exposure to defensive assets, or even cash preservation in fixed deposits paying interest, can serve as mitigating factors for certain portfolios. Prices of bonds held to maturity could adjust according to current market realities as the bonds reach maturity, however liquidity needs must be carefully monitored; a painful lesson in the case of SVB. 

2. Counterparty Default

Rising interest rates increase costs of borrowing for businesses and evidently become a cause for concern. For bonds, in particular, the risk of default on credit should be considered as a critical risk, along with interest rate and concentration risks. The risk of default is more relevant to the financial stability of corporate bond issuers, due to contagion risk, rather than in the case of sovereign bonds.

Counterparty failure to meet contractual obligations can also prove harmful for other income strategies, such as loan origination, property renting, energy production and distribution, and vessel chartering. Last but not least, investors holding equity interest in a defaulting company may lose up to 100% of their investment, whereas defaults of counterparties may generally cause disruptions in supply chains or create other operational hiccups for a private business. 

Ways of determining whether a counterparty is susceptible to default due to interest rate hikes include, amongst others, review of the underlying company’s financial results and in particular cash flows, following credit ratings/reviews, and using credit probability models and stress scenarios that aim at testing the magnitude of repercussions of interest rate hikes. 

We have recently witnessed the speed at which such events can unfold after observing Credit Suisse’s virtually overnight takeover by UBS. The elimination of the value of Additional Tier 1 (AT1) bonds is testimony that identification of red flags and corrective measures (e.g. prompt liquidation of positions) are of utmost importance. Ways of mitigating against an imminent default include investing in bonds that are higher on the seniority hierarchy scale, securing mortgages or upfront deposit amounts, or getting insurance against counterparty repayment defaults. 

3. Disruption in Market Liquidity 

The ongoing rate hikes caused a disruption in market liquidity due to the overall uncertainty, which climaxed when banks started falling. Fund Managers with portfolios exposed to assets such as subordinated paper, distressed equity and consumer cargos, may face issues in realizing their positions since the markets may not have sufficient liquidity to absorb them.

Inability to liquidate a position becomes challenging, and potentially detrimental, when the fund portfolio itself requires liquidity to meet its own obligations. Entities not deemed “too big to fail” are not likely to receive a rescue or a credit line (as in the case of First Republic Bank), therefore the fund manager may have to seek other alternatives, including stepping in to cover the fund’s working capital with own funds, or receiving finance from lenders (after cautiously assessing the risk of increased borrowing costs). 

4. “Investor Runs” and Reduced demand for Fund Units

During periods of uncertainty, non-institutional investors tend to be more conservative and, in acts of panic, may be prompted to request the redemption of their money. Nowadays, access to information that may be exaggerated could contribute to unfounded investor sentiment and decisions. Mass redemption requests not only reduce the size and fire power of a fund, but in a self-fulfilling manner, may also lead to inability to meet redemption outflows in the case of unavailable bids for liquefying portfolio positions.

Fortunately, both market practices and regulatory frameworks have introduced liquidity management tools which may be used during periods of stress, including gates, deferral periods and temporary suspension of redemptions.

5. Increased Cost of Financing

As interest rates increase, it is only natural that the cost of borrowing will also increase. Increasing financing costs result in a reduction of profitability and disturbance in projected cash flows. A preferred practice amongst fund managers to protect their portfolios against further interest rate hikes is to enter into a derivative contractual instrument, such as interest rate swap contracts, that would mitigate the risk of a change in interest rates.

6. Unfavorable Exchange Rate Fluctuations

This applies to funds exposed to currencies other than their base currency. Interest rate changes affect the forces of demand and supply, which affect the linked currency’s value. Higher interest rates tend to lead to increased demand for the local currency and therefore to its appreciation against foreign currencies. Depending on its foreign currency exposures and the aggressiveness of the respective central banks, fund portfolios may realize noticeable gains or losses in the short run due to exchange rate fluctuations.

Capital markets and financial institutions offer a plethora of tools that can effectively minimize losses occurring from unfavoured exchange rate fluctuations, such as currency swaps and forward contracts.

All in all, Fund Managers may consider remaining prudent during times like these. Additional developments (e.g. OPEC+’s latest unexpected decision to reduce oil supply) may fuel additional inflation and, therefore, force the hand of central banks to increase rates further. During such volatile times, staying on top of market and geopolitical developments must be complemented by proactive measures to manage and mitigate identified risks.