Hedging Interest Rate Risk

Richard Croft
February 17, 2015
4 minutes read

This past week we saw some indications that longer term interest rates may actually rise. Something investors have been talking about for the past two years!

It is not that interest rates will rise significantly, it is more about what impact any change in mindset will have on your portfolio. More importantly, what steps can one take to manage interest rate risk?

What we know is that higher interest rates mean lower bond prices. Think about interest rates and bond prices as opposite ends of a teeter totter. Duration also plays an important role as longer term interest rates and bond prices will be more volatile than shorter term rates and prices i much the same way as a longer teeter totter moves more dramatically than the shorter version.

Higher interest rates do not affect stocks in the same way. Insurance companies for example, may be hurt by rising rates if they have a significant portion of their investment portfolio geared to annuities. Mind you that depends on whether annuitant recipients have options in terms of exiting contracts. On the other hand, it helps their life insurance business because they can earn higher returns on the portion of their capital tied to death benefits.

If interest rates do rise significantly, it can have a negative impact on auto dealers and furniture companies who have to pay higher costs to maintain their inventory. On the other hand, it would have little impact on grocery store chains that turn over inventory rapidly.

Banks typically benefit from higher interest rates especially if rates rise faster on the mid to longer end of the yield curve. Banks typically borrow money at the shorter end of the curve to finance mortgages at the mid to longer end of the curve.

We witnessed some of the advantages from higher rates flow through to Canadian banks over the past week. All of Canada’s major banks turned in some decent performance and I suspect we will see more of the same over the next few months. With that in mind banks provide the twin benefits of an excellent hedge against the possibility of higher rates and solid dividends should you have to buy and hold. Any of Canada’s major banks would fit the bill if you buy into this scenario.

A couple of ways to play this; 1) buy the shares and write slightly out of the money calls with two to four months to expiry or 2) for more aggressive traders take a look at buying longer term calls for capital appreciation with limited risk.

As an example you could look at buying shares of Bank of Montreal (symbol BMO, Friday’s close $78.69) and writing the April 80 calls at $1.70. The two month return if exercised is 3.83%, return if unchanged is 2.16% and downside protection is $76.99.

The other option is to buy BMO January 78 calls at $5.40. These calls are 89 cents in-the-money and will be profitable if BMO is above $83.40 by the end of the year. They may also be profitable in the interim should BMO spike on any news of higher rates.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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