For decades, interest rates fell in Europe and the United States. What annoyed fans of savings accounts was well received by bondholders, as falling interest rates regularly lead to price gains. But this golden era could now be at an end. One indication of this is current yields in Germany: Since their low almost exactly two years ago, yields have mainly gone up, even if only slightly overall. The current yield is the weighted average yield of representative bonds from public issuers and similar fixed-income securities in Germany. It is calculated by the Deutsche Bundesbank on a daily basis.
The bond experts at DWS expect that this modest uptrend is likely to continue, particularly from next year on. To date, central banks from industrialized countries have not been seen to hurry to raise interest rates. At the end of July 2018, both the Bank of Japan and the European Central Bank confirmed their intention to keep rates low until at least next year. In addition, the US Federal Reserve (Fed) did not raise key interest rates at the start of August – despite the strong growth in the US economy.
This is where danger lurks
However, the Fed is assuming that key rates will be raised another two times by the end of the year. Given the comparatively higher economic growth rates and low unemployment, it has been following a path of cautious interest rate hikes since the end of 2015. Key interest rates have increased seven times since then. What is happening in the USA could soon also be the right course of action in Europe, too. After all, the Eurozone economy is now growing more quickly than it was.
Rising interest rates – while that may sound good at first, this is not necessarily the case for bondholders. Their problem is that bond yields and prices always move in the opposite direction. When market interest rates rise, the sober logic of the markets dictates that bond prices will fall. This is because bonds that have already been issued become less attractive when interest rates rise: With a new bond, an investor would benefit from higher interest rates, meaning they would generate better yields in return for investing the same amount of money than from the older bond, which generates less interest.
In an environment with rising interest rates, this means that the price of already issued bonds will continue to fall until their yield is once again adjusted in line with the new, higher interest rate levels. In short, any investors who already hold bonds and want to sell them before maturity may incur losses when interest rates rise.
Countering the effect with floating-rate notes
One way of countering potential price losses caused by rising interest rates is to invest in bonds with variable interest rates. The reason for this is that the interest paid on these floating-rate notes is linked to the development of market interest rates. If market interest rates rise, the interest rate of the floater also rises, and vice versa. This means that the price of the floater reacts minimally to any changes in interest rate levels. The adaptation to a new interest rate environment is not reflected in the price but the interest coupon.
The Deutsche Floating Rate Notes USD LD fund primarily invests in this sort of variable-interest-bearing securities denominated in US dollars. By investing in US floaters, investors are not only largely immune from interest rate trends in Europe and the USA, but they also have the opportunity to benefit from the higher rates in the United States. The fund manager largely neutralizes any exchange rate fluctuations by making use of hedging transactions.