Defying Gravity: How to Position a Portfolio to Benefit from Higher Interest Rates
February 2023
Quote of the Month
“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” – Warren Buffett
Overview
- Just as low interest rates create a low gravitational pull on asset prices, higher interest rates increase the gravitational pull on asset prices downward
- Interest rates are likely going higher 🡪 this is bad for nearly every asset class: stocks, bonds, real estate, etc.
- At Athos Capital we are investing primarily in two asset classes that benefit from higher interest rates
- Floating rate private credit: yields of 10% plus and going higher
- Stable value money market funds: yields of 4.5% and going higher
Interest Rate Expectations Move Higher
The financial markets continue to grapple with the prospect of higher interest rates for longer as the battle to bring inflation down continues to last longer than previously expected. As you can see from the chart below, interest rate expectations rose consistently during February as a series of strong economic and inflation data shows the economy and inflation remain resilient despite the Fed’s efforts to slow things down.
Higher interest rates are generally a headwind for the vast majority of financial assets (stocks, bonds, real estate, etc.) as a higher risk free rate reduces the mathematical value of future cash flows from those assets. Additionally, a higher risk free rate provides an increasingly compelling investment alternative – when interest rates are zero investors are forced out the risk spectrum to achieve a return, when interest rates are 5% why take the risk? With rising interest rates and eventually a slowdown in the economy, what are investors to do?
How do you position a portfolio to benefit from higher interest rates?
There are two main asset classes that benefit from higher interest rates. Both of these asset classes benefit as interest rates move higher as they are both floating rate and thus have a higher rate of income to pass along to us as the investors.
- Floating rate private credit
- Money market funds
Floating rate private credit is in many ways the perfect asset class for the current environment. As interest rates have moved higher the interest paid on the debt increases and benefits the investor who owns the loan. Additionally, because the loans are private and relatively short in duration there is no daily mark-to-market of the loans, thus insulating the investors from the daily volatility and wild swings of the stock and bond markets. If the Federal Reserve continues to raise interest rates (currently 4.75% and expected to go to at least 5.5%) then the yield on these investments will increase commensurately. Today our favorite floating rate private credit funds yield 10%.
Money market funds are also increasingly attractive in the current environment. With zero daily volatility and yields now close to 5%, the return on cash now serves as an attractive alternative to stocks and bonds. Just as with the floating rate private credit funds, as the Federal Reserve raises interest rates the income an investor receives from owning these funds also increases. Today stable value money market funds yield 4.5%.
Importantly, a portfolio focused on these two asset classes not only provides high income with low volatility it is almost completely uncorrelated to the stock and bond markets allowing for flexibility and the ability to be a buyer of equities if they move sharply lower. In other words, we get paid to wait for attractive buying opportunities.
High Income, Low Volatility
Also of considerable importance is the low volatility associated with both asset classes. As you can see from the chart below, the Athos Capital floating rate private credit investments (interval funds) have virtually no volatility and virtually no correlation to the ups and downs of the stock and bond markets.
Don’t Fight The Fed
In closing, we believe most market participants continue to underestimate just how persistent and “sticky” inflation will prove to be. The primary driver of inflation now is on the services side and is being pushed higher by a labor market that has structurally changed since the COVID-19 pandemic. The market continues to fight the Fed and remains too hopeful that we will see a pause in rate hikes and eventual rate cuts. Instead of fighting the Fed we are choosing to be on the same side as the Fed. Floating rate private credit and stable value money market funds are two very low risk and low volatility ways to accomplish this.
While we find floating rate private credit and money market funds to be among the most attractive asset classes right now we remain ever vigilant and nimble and will adjust as market and economic conditions adjust.
As always, I look forward to hearing from you.
Sincerely,
Henry A. Miketa
310-971-4765