Navigating Interest Rate Risk in a High-Rate Era

The Shifting Landscape: Challenges and Outlook in a High-Rate Era

The “Annus Horribilis” of 2022 and Its Aftermath

The rapid escalation of interest rates during 2022-2023 had a severe and memorable impact on fixed-income portfolios. As central banks aggressively tightened monetary policy to combat surging inflation, yields across the curve rose sharply. This inverse relationship between yields and bond prices meant that existing bonds, particularly those with longer maturities, experienced significant capital losses. Vanguard characterised 2022 as an “annus horribilis” for bond markets, with global bonds posting double-digit losses. 

Compounding the pain for investors, global equities also fell sharply during this period, marking the first time since 1977 that these two major asset classes declined in such a correlated fashion. For instance, the S&P 500 fell 19% in 2022, its worst annual performance since 2008. This market behaviour was primarily a function of duration risk, the sensitivity of bond prices to interest rate changes. The period shattered the long-held illusion for some that bonds offer a perpetual safe haven and starkly underscored the pervasive reality of interest rate risk, even within portfolios previously considered well-diversified.

The breakdown of the traditional negative stock-bond correlation observed in 2022 carries significant implications. Standard diversification playbooks, which often rely on bonds to cushion equity drawdowns, may require substantial revision. Investors can no longer automatically assume that fixed income will serve as a reliable counterbalance to equity market volatility in all economic environments. If periods of high inflation and aggressive central bank tightening become more frequent responses to economic shocks, such correlated downturns in both asset classes could recur. This necessitates a search for alternative or more nuanced diversification strategies that demonstrate robustness across different inflation and interest rate regimes.

The Current Global Economic Chessboard (as of early-mid 2025)

Looking ahead, the global economic environment presents a complex picture. The OECD projects global GDP growth to slow from 3.3% in 2024 to 2.9% in both 2025 and 2026. This slowdown is anticipated to be concentrated in several major economies, including the United States. While headline inflation in G20 economies is expected to moderate, from 6.2% to 3.6% in 2025 and 3.2% in 2026, OECD-wide inflation is projected to be 4.2% in 2025, higher than previously anticipated, suggesting that inflation may prove more persistent. Key risks to this outlook include further trade fragmentation, which could intensify the growth slowdown and fuel inflation, and the continuation of tight financial conditions.

This macroeconomic backdrop suggests an environment where central bank interest rate cuts may not be as swift or substantial as some market participants might hope. Economic conditions could remain challenging for risk assets, and the “repricing of risk in financial markets” noted by the OECD is likely an ongoing process. The initial shock of the 2022 rate hikes might be followed by secondary effects as markets continue to digest higher funding costs. This could lead to a deterioration in credit quality in certain sectors or expose liquidity challenges, particularly for entities that became heavily leveraged during the low-rate era. Therefore, interest rate risk management must incorporate a forward-looking perspective on credit risk and liquidity risk, as these are often deeply intertwined.

The OECD’s projection of persistent inflation alongside slowing growth also points towards a potentially stagflationary environment. Such conditions have historically been challenging for most traditional asset classes. This makes active risk management and the adoption of sophisticated strategies, such as dynamic duration management, specific hedging techniques, and careful consideration of real assets, even more crucial, as conventional growth-oriented investment approaches or passive fixed-income strategies may significantly underperform.

Persistent Challenges for Investors

Several persistent challenges confront investors in this high-rate era:

• Increased Volatility: Bond market volatility, as measured by indicators like the MOVE Index, has remained elevated, suggesting that sharp price swings may continue to be a feature of the fixed-income landscape.
• Unstable Correlations: The correlations between different sovereign bond markets and U.S. Treasuries can be unstable and vary significantly over time. This complicates global fixed income management and diversification efforts, as historical relationships may not hold true in the future.
• Policy Uncertainty: The OECD has highlighted heightened policy uncertainty as a significant risk to growth. This uncertainty, stemming from geopolitical tensions, trade disputes, and the future path of monetary policy, makes it more difficult for investors to form stable expectations and can lead to increased market skittishness.
• Reinvestment Risk: Even if interest rates begin a gradual decline from their current highs, they are unlikely to return to the ultra-low levels of the past decade. In such an environment, reinvesting the proceeds from maturing bonds or called securities at potentially lower prevailing yields becomes a significant concern for income-focused investors and those with specific liability-matching needs.

Mastering Duration: Strategic Portfolio Adjustments

Understanding Duration as the Primary Risk Lever

Duration is a foundational concept in fixed-income investing, measuring a bond’s or a portfolio’s price sensitivity to changes in interest rates. In essence, it quantifies the approximate percentage change in a bond’s price for a 1% change in its yield. Modified duration provides this sensitivity measure, while effective duration is used for bonds with embedded options, accounting for how changes in interest rates might alter future cash flows. Understanding and managing duration is the first line of defense, or offense, in controlling a portfolio’s exposure to interest rate movements. It is a key tool for risk quantification.

Strategic Duration Adjustments

Portfolio managers can strategically adjust duration based on their outlook for interest rates:

• Shortening Duration: In an environment where interest rates are expected to rise, shortening a portfolio’s overall duration can reduce its price sensitivity to these hikes, thereby mitigating potential capital losses. This involves shifting towards bonds with shorter maturities or those with features that reduce interest rate sensitivity.
• Lengthening Duration: Conversely, if interest rates are anticipated to fall, extending portfolio duration can maximise potential capital gains as bond prices appreciate. This would involve allocating more to longer-maturity bonds.
• Dynamic/Active Duration Management: Given the inherent difficulty in accurately predicting interest rate movements, a static duration posture is often suboptimal. Active duration management involves dynamically adjusting the portfolio’s duration in response to evolving market conditions, economic data, and central bank signaling. T. Rowe Price, for example, advocates for managing duration actively and within a wide latitude, enabling portfolio managers to adapt to changing market cycles by quickly cutting duration when rates are rising or increasing it when rates are falling. They emphasise that a simple strategy of being persistently long sovereign bond duration is ineffective in a rising-rate environment. This active approach requires considerable skill, in-depth research, and the operational flexibility to implement changes promptly.

The emphasis on active duration management implies that generating alpha in fixed income, particularly in a high-rate and volatile environment, is becoming less about passive beta exposure and more about skillful tactical adjustments. This includes identifying relative value opportunities along the yield curve and across different sovereign markets, suggesting an increased value proposition for active fixed income managers with demonstrated expertise in these nuanced areas.

Beyond Basic Duration: Advanced Considerations

While standard duration measures are useful, a more sophisticated approach incorporates additional factors:

• Analytical vs. Empirical Duration: Analytical duration measures like modified or effective duration, while widely used, can oversimplify a bond’s price sensitivity by ignoring certain real-life variables and, notably, convexity. Empirical duration, in contrast, is calculated using historical regression analysis of a bond’s price changes against changes in a benchmark yield (e.g., U.S. Treasuries). This can provide a more practical, market-observed measure of sensitivity. T. Rowe Price suggests that empirical duration can be a better practical measure, though it relies on historical data. To mitigate this dependency, they advocate using multiple lookback periods to observe the stability of the regression and capture recent market behavior. The debate between these approaches highlights a broader trend: as markets become more complex and data more abundant, purely model-driven approaches based on simplified assumptions are evolving towards more empirically validated, data-intensive methods. This shift has significant implications for the talent, technology, and analytical capabilities required within risk management functions.
• Convexity: Convexity measures the rate of change of duration itself. It describes the curvature in the relationship between bond prices and yields. Positive convexity is a desirable characteristic, especially in volatile interest rate environments. A bond or portfolio with higher positive convexity will experience greater capital gains for a given fall in yields than the corresponding capital losses for an equivalent rise in yields. Ignoring convexity, particularly when there are large changes in yields, will typically underestimate the price of a noncallable, option-free bond. Consequently, securities with high levels of convexity often command a premium in the market.
• Curve Positioning: Interest rate risk is not monolithic. Risks and opportunities exist not only in the overall duration of a portfolio but also in how that duration exposure is distributed across the yield curve (e.g., allocations to the short end, belly, or long end of the curve). Different segments of the yield curve are influenced by different factors: the short end is largely driven by central bank policy rates, while longer-dated yields are more affected by long-term expectations for growth and inflation, as well as technical factors like fiscal dynamics impacting bond supply. Key rate duration, which measures sensitivity to shifts in specific points along the curve, is more accurate when yield curves shift in a nonparallel fashion. Furthermore, characteristics like inverted yield curves, where short-term rates are higher than long-term rates, present unattractive carry and roll-down dynamics for longer-dated positions that must be considered.

Practical Duration Management Strategies

Several established strategies can be employed to manage portfolio duration:

• Barbell Strategy: This involves investing in a combination of short-duration bonds (for liquidity and lower risk) and long-duration bonds (for yield enhancement and potential capital appreciation if rates fall). This strategy aims to balance income generation with risk mitigation.
• Bullet Strategy: This strategy focuses on investing in bonds that mature around the same specific future date. The primary goal is to minimise reinvestment risk for a known future liability or financial goal.
• Laddering Strategy: This involves staggering the maturities of bonds in a portfolio over a period of years. As bonds mature, proceeds can be reinvested at prevailing rates. This approach helps to offset interest rate variability over time, maintain a relatively consistent cash flow, and mitigate reinvestment risk.

The Role of Floating Rate Notes (FRNs)

Floating Rate Notes (FRNs) are debt instruments whose coupon payments are not fixed but adjust periodically based on a predetermined benchmark short-term interest rate, such as the Secured Overnight Financing Rate (SOFR), plus a fixed spread. Because their coupons reset with changes in short-term rates, FRNs inherently have very low, or near-zero, duration. This characteristic makes them a useful tool for reducing overall portfolio duration and mitigating price declines in a rising interest rate environment. They are often considered for capital preservation and for helping portfolios keep pace with inflation when rates are expected to rise.

While FRNs offer low duration, their proliferation and reliance on benchmarks like SOFR could introduce new forms of basis risk if the FRN market behaves differently from other short-term instruments or if liquidity in specific FRNs diminishes during periods of market stress. Investors must also consider the credit risk of the FRN issuer and be aware that many FRNs come with caps (maximum coupon rates) or floors (minimum coupon rates), which can limit upside potential or downside protection, respectively.

Table 1: Overview of Duration Management Strategies

Advanced Hedging Techniques: Shielding Portfolios from Adverse Rate Moves

The Rationale for Hedging

While duration management adjusts a portfolio’s overall sensitivity to interest rate changes, hedging with derivative instruments allows for more precise targeting of specific risks. It can also be used to achieve desired risk-return profiles without necessarily altering the underlying physical portfolio composition. Derivatives can modify investment positions for hedging purposes, create desired payoff structures, or implement asset allocation decisions. Although hedging typically involves a cost, either direct (like an option premium) or indirect (like opportunity cost), the potential cost of a major adverse interest rate move in an unhedged portfolio can be far more substantial, even disastrous. Therefore, hedging is a proactive risk mitigation tool that warrants careful consideration.

The choice of hedging instrument is not merely a technical decision but a strategic one, reflecting an institution’s risk appetite, market view, and cost tolerance. For instance, purchasing an option (such as a cap or floor) requires an upfront premium payment but offers asymmetric protection, limiting downside risk while allowing participation in favourable movements. In contrast, an interest rate swap might be zero-cost at initiation but creates an ongoing obligation and exposes the parties to counterparty risk. 

The increasing sophistication and accessibility of derivatives mean that a wider range of institutions can theoretically implement complex hedging strategies. However, this accessibility also elevates the risk of misuse or misunderstanding if these powerful instruments are not managed with adequate expertise and robust internal controls. The 1994 bond market crisis, which involved sophisticated market players, serves as a reminder that significant losses can occur even when advanced instruments are available.

Furthermore, the transition in benchmark rates from LIBOR to SOFR (Secured Overnight Financing Rate) and other alternative reference rates has introduced new complexities and potential basis risks into the derivatives markets. Hedgers must be acutely aware of the characteristics of these new benchmark rates and how they might behave relative to their underlying exposures, especially during periods of market stress.

Interest Rate Swaps (IRS)

• Mechanics: An Interest Rate Swap is an over-the-counter (OTC) contract between two parties who agree to exchange streams of future interest payments over a specified period, based on a notional principal amount. The principal itself is typically not exchanged. The most common type is the “plain vanilla” swap, where one party pays a fixed interest rate and receives a floating interest rate (often tied to a benchmark like SOFR), while the counterparty pays the floating rate and receives the fixed rate.
• Use Cases: IRS are versatile instruments. They can be used to:

• • Convert a fixed-rate liability into a floating-rate one, or a floating-rate asset into a fixed-rate one. For example, a company that has issued fixed-rate bonds but prefers floating-rate exposure can enter a swap to receive fixed payments (to offset its bond coupons) and pay floating-rate payments.
  • Manage the duration gap between assets and liabilities, a common application in Liability-Driven Investing (LDI) for pension funds, which often use receive-fixed swaps to lengthen asset duration.
  • Lock in current interest rates for anticipated future financing needs.
  • Change the tenor or type of a floating rate index being paid or received (a “basis swap”).

• Considerations: Being OTC contracts, IRS carry counterparty risk (the risk that the other party defaults on its obligations). Basis risk can arise if the floating leg of the swap does not perfectly correlate with the interest rate exposure being hedged. Liquidity can also be a concern for highly customised swaps, although plain vanilla swaps are generally liquid.

Interest Rate Futures

• Mechanics: Interest rate futures are standardised, exchange-traded contracts that obligate the buyer to purchase, or the seller to sell, an interest-rate-sensitive underlying asset (such as a Treasury bond or a notional short-term deposit) at a specified price on a future date. They can be short-dated (e.g., SOFR futures, Fed Funds futures, reflecting expectations for overnight rates) or longer-dated (e.g., 2-year, 5-year, 10-year, 30-year Treasury futures, reflecting yields on government bonds).
• Use Cases: Futures are commonly used for:

• • Short-term risk management and modifying a portfolio’s overall interest rate exposure.
  • Hedging against parallel shifts in the yield curve.
  • Implementing cash equitisation strategies, where cash holdings are synthetically invested in the market using futures to avoid performance drag.
  • To effectively hedge interest rate risk with bond futures, portfolio managers must determine the Basis Point Value (BPV) of the portfolio to be hedged, the target BPV, and the BPV of the futures contract. The BPV of the futures contract is itself determined by the BPV of the “cheapest-to-deliver” (CTD) bond eligible for delivery under the contract terms, and its specific conversion factor (CF). The number of futures contracts to buy or sell is then calculated using the Basis Point Value Hedge Ratio (BPVHR): BPVHR=((BPVT​−BPVP​)/BPVCTD​)×CF.

• Considerations: Futures contracts require posting initial and variation margin, which can create liquidity demands. Basis risk is a key concern, particularly with bond futures, due to the cheapest-to-deliver dynamic (where multiple bonds can be delivered against the contract, and the seller will choose the most economical one, whose characteristics may not perfectly match the hedged exposure). Contract roll risk arises as futures expire and positions need to be rolled into new contracts, potentially at different prices. The standardisation of futures means they may not provide a perfect hedge for very specific or unique exposures.

Options on Interest Rates (Caps, Floors, Collars, Swaptions)

Interest rate options provide the buyer with the right, but not the obligation, to take a certain action related to interest rates at a predetermined “strike” rate on or before an expiration date. This asymmetric payoff profile makes them flexible hedging tools.

• Mechanics & Use Cases:

• • Caps: An interest rate cap protects a borrower with floating-rate debt from interest rates rising above a specified ceiling (the strike rate). If the reference rate (e.g., SOFR) exceeds the strike rate, the seller of the cap pays the difference to the buyer, effectively “capping” the buyer’s interest expense. A cap is essentially a series of individual options, or “caplets,” for each period the agreement covers.
  • Floors: An interest rate floor protects a lender with floating-rate assets from interest rates falling below a specified level. If the reference rate falls below the strike, the seller of the floor pays the difference. A floor consists of a series of “floorlets”.
  • Collars: A collar is created by simultaneously buying a cap and selling a floor (or vice-versa). This strategy limits interest rate exposure to a specific range, or “collar.” A “zero-cost collar” can often be structured by choosing strike rates such that the premium received from selling one option offsets the premium paid for buying the other, though this typically means giving up some potential profit from favourable rate movements.
  • Swaptions: A swaption is an option that gives the buyer the right, but not the obligation, to enter into an interest rate swap at a future date at specified terms. A “receiver swaption” grants the right to receive a fixed rate and pay a floating rate, while a “payer swaption” grants the right to pay fixed and receive floating. Pension funds, for example, might use receiver swaptions if they anticipate needing to hedge against falling rates in the future (to lock in a receiving fixed rate) or payer swaptions if they expect rates to rise and want the option to pay fixed.

• Considerations: The primary cost of buying an option is the upfront premium paid. Options are subject to time decay (theta), where their value erodes as they approach expiration. Their prices are also sensitive to changes in interest rate volatility (vega). The complexity of option strategies requires a thorough understanding of their payoff profiles and risk characteristics.

Forward Rate Agreements (FRAs)

• Mechanics: A Forward Rate Agreement is an OTC contract that locks in an interest rate for a specified notional principal amount for a single, specified future period. FRAs are typically settled in cash based on the difference between the agreed-upon forward rate and the actual spot rate at the settlement date.
• Use Cases: FRAs are ideal for hedging the interest rate risk on a single, known future borrowing or lending transaction. A series of FRAs can be conceptually similar to an interest rate swap; however, unlike a swap, where all payments are typically based on the same fixed rate, each FRA in a series can be priced at a different forward rate unless the term structure is flat. They offer tailored hedging for specific future needs.
• Considerations: Like other OTC derivatives, FRAs carry counterparty risk. They are generally less liquid than exchange-traded futures contracts.

Table 2: Comparison of Hedging Instruments

The Power of Diversification: Spreading Risk in a Concentrated Rate Environment

Diversification Beyond the Basics

In an economic environment where rising interest rates can exert simultaneous pressure on many asset classes, as witnessed in 2022 when both global bonds and equities experienced sharp declines, traditional diversification strategies, such as a simple stock/bond mix, may prove insufficient. The fundamental principle of diversification is to combine assets with low or negative correlations, meaning they tend to move independently or in opposite directions under various market conditions. When correlations turn positive across major asset classes, the benefits of naive diversification diminish. This necessitates a more creative and nuanced approach to identifying sources of uncorrelated returns and managing overall portfolio risk.

Effective diversification in a high-rate era requires moving beyond simple asset class labels to understand the underlying factor exposures that drive returns and risks. This includes sensitivity to real interest rates, inflation surprises, credit spreads, liquidity conditions, and other macroeconomic variables. A granular, factor-based approach to diversification is needed to build resilient portfolios, rather than merely mixing asset classes based on historical correlations that may not persist.

Diversifying Across the Yield Curve

Within a fixed-income allocation, instead of concentrating investments in one specific segment of the yield curve, investors can spread their holdings across various maturities, short, intermediate, and long-term. This approach can be linked to strategies like bond laddering but with a broader objective of capturing different risk and return dynamics inherent at different points on the curve. Different parts of the yield curve respond dissimilarly to economic news, monetary policy shifts, and changes in investor sentiment. For instance, the short end is highly sensitive to central bank policy rates, while the long end is more influenced by long-term growth and inflation expectations. Diversifying across the curve can help smooth returns and reduce the impact of specific types of yield curve movements (e.g., a steepening or flattening).

Cross-Asset Class Diversification for Interest Rate Sensitivity

To mitigate the impact of rising interest rates, investors should look to asset classes that exhibit different sensitivities to rate changes:

• Real Assets: Assets such as real estate and commodities are often considered for their potential to offer inflation protection and potentially different interest rate sensitivities compared to traditional financial assets.
• Real Estate: Can offer inflation protection through rental income streams that may adjust with inflation and through potential appreciation in property values over the long term. However, commercial real estate can also be negatively impacted by higher mortgage rates, which increase financing costs and can dampen transaction activity and valuations. The “denominator effect,” where falling public market valuations make private real estate allocations appear overweight, also presented challenges for institutional investors in 2022-2023, potentially constraining new investments just when opportunities might arise. This highlights the importance of managing liquidity and commitment pacing for illiquid private assets when public markets are volatile due to interest rate shifts.
• Commodities: In periods of high inflation and robust economic growth, commodities often perform well due to increased demand. However, commodities are a diverse group, and their prices are driven by a complex interplay of supply, demand, geopolitical factors, and currency movements, not just interest rates.
• Equities with Low Rate Sensitivity or Potential Benefits: Certain equity sectors or investment factors may be less vulnerable or even benefit from a rising interest rate environment.

• • Defensive sectors like utilities, healthcare, and consumer staples are often cited as holding up relatively well during rate hike cycles, as demand for their products and services tends to be less economically sensitive.
  • Financial sector companies, particularly banks, may benefit from wider net interest margins (NIMs) in a rising rate environment, as they can earn more on their assets (loans) relative to what they pay on their liabilities (deposits).
  • Value stocks, which are often characterised by more stable cash flows and lower valuations, may outperform growth stocks (whose valuations are more dependent on distant future earnings and thus more sensitive to discount rate changes) in a rising rate environment. This requires careful sector and company-specific analysis.

• Alternative Investments: Hedge funds, private equity, and private credit are increasingly considered by institutional investors for their potential diversification benefits and unique risk-return profiles.

• • Many hedge fund strategies aim to provide returns that are uncorrelated with traditional markets and may be able to capitalise on increased volatility and market dislocations caused by shifting interest rates.
  • Private equity and private credit can offer different return streams, but they come with significant illiquidity, longer time horizons, and often higher fees. These are typically suitable only for sophisticated investors with the capacity to manage these characteristics.

Geographic Diversification

Spreading investments across different countries and regions is a long-standing diversification principle. It can help mitigate exposure to any single country’s specific interest rate cycle, economic shocks, or political risks. For example, emerging markets may offer different growth and interest rate dynamics compared to developed markets.

However, the effectiveness of geographic diversification in mitigating systemic interest rate shocks can be reduced by increasing global economic interconnectedness and correlated central bank policy responses, especially during major global inflationary episodes like the one seen recently. The 1994 bond market crisis, for instance, spread rapidly across global markets. While correlations between global bond markets can vary, and individual country analysis remains essential, investors should not assume that international diversification will always insulate them from broad shifts in the global interest rate environment. Geographic diversification should therefore be informed by an understanding of how different economies and their respective monetary policies might diverge or converge under various global scenarios.

The Role of Inflation-Linked Bonds (ILBs)

• Mechanics: Inflation-Linked Bonds (ILBs), such as U.S. Treasury Inflation-Protected Securities (TIPS), are bonds whose principal value (and consequently their coupon payments, which are a fixed percentage of the adjusted principal) is indexed to a recognised measure of inflation, like the Consumer Price Index (CPI) or Retail Price Index (RPI).
• Use Case: ILBs are specifically designed to protect investors’ purchasing power from being eroded by inflation. They aim to provide a “real” return over inflation, as their cash flows are contractually linked to changes in the price level. Short-duration ILBs can be particularly useful for investors seeking to hedge inflation risk without taking on excessive exposure to interest rate duration.
• Considerations in a Rising Rate Environment: While ILBs offer protection against inflation, their market prices are still sensitive to changes in real interest rates (nominal interest rates minus expected inflation). If nominal interest rates rise more rapidly than inflation expectations, the real yield on ILBs will increase, causing their prices to fall, similar to conventional nominal bonds. ILBs tend to perform best in stable or low real interest rate environments and historically have done well in the later stages of an economic cycle. They are not a perfect substitute for nominal bonds if the primary concern is a rise in nominal interest rates driven by factors other than, or in excess of, inflation.

Fortifying Portfolios: The Imperative of Scenario Analysis and Stress Testing

Defining Scenario Analysis and Stress Testing

Scenario analysis is a forward-looking risk management technique used to estimate the potential impact on a portfolio’s value under a given set of hypothetical changes in key financial variables, such as interest rates, exchange rates, or equity market levels. It is a “what-if” analysis that involves defining specific scenarios, modelling their impact on portfolio assets and liabilities, assessing the outcomes, and then developing or adjusting strategies accordingly.

Stress testing is a specific form of scenario analysis that focuses on the impact of extreme but plausible unfavourable events. It aims to assess the resilience of a portfolio or institution to severe market shocks. For interest rate risk, this involves modelling the effects of significant and often sudden changes in interest rates or the shape of the yield curve. Stress testing is considered an integral part of robust Interest Rate Risk (IRR) management.

The evolution of recommended stress tests from simple parallel shifts to more complex non-parallel shifts, twists, and sophisticated model-driven scenarios reflects an increasing understanding within the financial industry and among regulators that interest rate risk is multi-dimensional. It cannot be adequately captured by a single metric like duration or by overly simplistic shock assumptions. Effective stress testing today requires a toolkit of scenarios that capture the diverse ways in which yield curves can change and interact with portfolio characteristics.

Why It’s Crucial in a High-Rate, Uncertain Environment

In the current environment, characterised by elevated interest rates and significant economic and policy uncertainty, scenario analysis and stress testing are more critical than ever. These tools help:

• Identify Vulnerabilities: They can reveal hidden vulnerabilities within a portfolio’s capital structure or an institution’s overall financial resilience that might not be apparent from standard historical risk measures like Value-at-Risk (VaR).
• Understand Inherent Risk: They allow management to gain a deeper understanding of the risks inherent in their balance sheet or investment portfolio under various adverse conditions.
• Proactive Contingency Planning: By simulating the impact of potential crises, stress tests enable the proactive evaluation and development of contingency plans and mitigating actions, rather than forcing reactive decisions during a crisis.

Common Interest Rate Scenarios to Test

A comprehensive stress-testing framework for interest rate risk should include a variety of scenarios:

• Parallel Shifts: These involve an instantaneous and sustained upward or downward shift in the entire yield curve by a specified number of basis points (e.g., +/- 100 bps, +/- 200 bps, +/- 300 bps). This is often a standard starting point for IRR stress testing.
• Yield Curve Twists (Flatteners/Steepeners): These scenarios model non-parallel shifts where different parts of the yield curve move by different amounts.

• A flattener occurs when short-term rates rise more than long-term rates, or long-term rates fall more than short-term rates.
• A steepener occurs when long-term rates rise more than short-term rates, or short-term rates fall more than long-term rates. Supervisory bodies often expect institutions to examine such yield curve twists, as different curve positioning strategies will have varying impacts.

• Yield Curve Inversions: This scenario models a situation where short-term interest rates become higher than long-term interest rates. The year 2022 saw significant yield curve flattening and, in some cases, inversion in many developed countries. Inverted curves present particular challenges, including unattractive carry and roll-down characteristics for longer-dated bonds.
• Changes in Volatility: Scenarios can be designed to assess the impact of a sudden increase or decrease in overall interest rate volatility on option- Mbs-heavy portfolios or on the cost of hedging.
• Basis Risk Scenarios: If derivative hedges are employed, it is crucial to test scenarios where the assumed correlation between the hedging instrument and the underlying hedged exposure breaks down. This can happen if, for example, the specific index underlying a swap behaves differently from the interest rate exposure of the asset or liability being hedged.

Methodological Considerations

The value of scenario analysis and stress testing is heavily dependent on the quality of their design and execution:

• Assumptions: It is paramount to recognise that these analyses are only as good as their underlying assumptions. All assumptions regarding rate movements, market responses, correlations, and portfolio behavior should be clearly defined, well-documented, and tailored to the specific institution’s products, risks, and market environment. The “garbage in, garbage out” caveat is particularly pertinent in unprecedented environments where relying too heavily on historical data for assumptions might miss novel risks. A blend of rigorous historical analysis and forward-looking expert judgment is often key to developing relevant and challenging scenarios. The 1994 crisis, for example, surprised markets that had become conditioned by a period of falling or stable rates, highlighting the danger of extrapolating past trends indefinitely.
• Severity and Plausibility: Scenarios should be designed to be significant enough to expose all material sources of IRR in the portfolio or balance sheet, yet remain plausible. The range of scenarios should be sufficient to identify repricing risk, basis risk, yield curve shape risk, and the risk embedded in options.
• Focus on Concentrations: Particular attention should be paid to concentrated positions within the portfolio, especially those that may be difficult to sell or hedge effectively during periods of market volatility without incurring material losses.
• Yield Curve Modelling: For more advanced and realistic scenario generation, especially for non-parallel shifts, yield curve parameterisation models can be employed. Models like the Nelson-Siegel framework or its variants (e.g., the Bjork-Christensen 5-factor model) allow for the decomposition of the yield curve into a few key factors (level, slope, curvature) whose historical behavior can be analysed to generate plausible shock scenarios.

Practical Application and Tools

Institutions can implement these tests using a variety of methods, from sophisticated in-house models to third-party software solutions. Specialised data and analytics platforms, such as those offered by IRStructure, can facilitate the complex calculations required for modelling portfolio cash flows and revaluing them under diverse interest rate environments.

Crucially, the results of scenario analysis and stress testing should not merely be filed away. 

They must be communicated effectively to senior management and the board of directors. These results should inform discussions about risk appetite, capital adequacy, and potential contingency actions. Indeed, stress testing results that exceed pre-defined policy limits should not automatically be viewed as compliance violations but rather as crucial discussion points. This reframes stress testing from a mere regulatory exercise to a strategic risk discovery tool, fostering an organisational culture of learning, adaptation, and proactive risk management.

Table 3: Illustrative Stress Test Scenarios for Interest Rate Risk

Echoes from the Past: Lessons from Historical Rate Cycles

Examining historical interest rate cycles provides invaluable context for navigating the current environment. While each period possesses unique characteristics, past episodes of significant rate shifts offer enduring lessons on market behaviour, risk vulnerabilities, and the consequences of policy actions.

A recurring theme across historical financial crises and periods of market stress, including those related to interest rate shocks, is that prolonged periods of stability or specific policy stances (like persistently low interest rates) can inadvertently breed complacency among investors. This complacency can encourage increased leverage, a search for yield in riskier assets, or the adoption of complex strategies whose vulnerabilities only become apparent when market conditions abruptly change. This behavioral finance aspect underscores the need for risk managers to actively guard against such “complacency cycles” and critically assess how prevailing market narratives might be masking underlying risks.

The “Great Bond Massacre” of 1994

• Background and Trigger: The early 1990s saw relatively low interest rates following the 1990/91 recession. The market, conditioned by this environment, was largely unprepared for the U.S. Federal Reserve’s decision to begin tightening monetary policy in February 1994. The Fed’s move, aimed at preempting inflationary pressures from a recovering economy, took many by surprise.
• Market Impact: The initial 25 basis point hike in the federal funds rate precipitated a sharp drop in U.S. government bond prices. More significantly, long-term bond yields rose dramatically throughout 1994, with the increase in long-term rates far exceeding the actual increases in official policy rates. This bond market turbulence quickly spread globally, leading to substantial capital losses worldwide, estimated by the Bank for International Settlements to be in the region of USD 1.5 trillion, nearly 10% of OECD countries’ GDP at the time.
• Key Lessons:

• • Central Bank Communication: A critical factor contributing to the severity of the 1994 crisis was the perception of unclear communication from the Federal Reserve, which left market expectations unanchored. The surprise element of the initial rate hike and subsequent uncertainty about the Fed’s ultimate intentions fueled volatility. In contrast, clearer communication strategies adopted by central banks in later tightening cycles, such as in 2004, are credited with contributing to more orderly market adjustments. This underscores that the effectiveness and market perception of central bank actions are heavily influenced by their communication and credibility. Ambiguity or surprises can amplify market volatility, whereas clear forward guidance can help anchor expectations, even if the policy path itself is restrictive.
  • Market Complacency and Leverage: Many investors had become accustomed to the stable or falling interest rate environment of the preceding years. This led to the adoption of strategies, including leveraged positions in fixed income and derivatives, that were highly vulnerable to a sudden rise in rates.
  • Global Contagion: The crisis starkly highlighted the increasing integration of global capital markets, as the shockwaves from U.S. rate hikes rapidly propagated to bond markets in Europe and Japan.

The 2004-2006 Fed Tightening Cycle

• Background and Rate Hikes: Following the dot-com bust and an associated recession in the early 2000s, the federal funds effective rate had fallen to around 1% by mid-2004. With robust GDP growth in 2003 (4.3%) and PCE inflation reaching 2.9% by June 2004, the Federal Open Market Committee (FOMC) initiated a cycle of rate increases. Over a period of 24 months, from June 2004 to July 2006, the Fed raised the federal funds rate by a total of 425 basis points, bringing it to 5.25%.
• Market Reaction and Economic Impact: Despite these rate hikes, PCE inflation continued to rise initially, from 2.9% to 3.4% over the same period, while the unemployment rate fell. The Richmond Fed’s analysis suggests the Fed may not have responded soon enough or strongly enough to stabilise prices in this cycle. The FOMC held the rate at 5.25% for over a year, during which inflation eventually declined. However, this tightening cycle ultimately preceded the Global Financial Crisis of 2007-2008.
• Impact on Banks (FDIC Comparison with 2022): During the 2004-2006 cycle, banks generally benefited from higher net interest income (NII). However, they also faced challenges, including decelerating loan and deposit growth, and decreased fair values of their asset holdings. Net Interest Margins (NIMs) for the industry tended to decrease during the 2004 cycle as funding costs rose to outweigh increases in asset yields. This contrasts with the 2022 cycle, where NIMs initially rebounded significantly before facing pressure from rising funding costs later on. Deposit growth weakened in both cycles as bank deposit rates lagged market rates, and reliance on wholesale funding increased.
• Key Lessons:

• • Inflation Persistence: The 2004-2006 experience demonstrated that inflation can remain stubborn even in the face of sustained monetary tightening, potentially requiring a prolonged period of restrictive policy to bring it under control.
  • The Rarity of “Soft Landings”: While the earlier 1994-1996 tightening cycle is sometimes cited as an example of a “soft landing” where inflation was contained without triggering a recession, the 2004-2006 cycle shows that even a gradual and well-communicated tightening can be followed by significant economic and financial instability.
• Economic Context Matters: The impact of rate hikes on bank performance and broader markets differs based on the prevailing economic conditions at the start of the cycle. Factors such as the composition of bank loan portfolios, levels of securities holdings, deposit funding structures, and overall economic leverage significantly influence outcomes.

Contrasting Past Cycles with the Current Environment (2022-Present)

The most recent rate hiking cycle, which began in March 2022, has several distinguishing features when compared to these historical episodes:

• Speed and Magnitude: The 2022-2023 hiking cycle was exceptionally rapid and large in terms of total basis points increase compared to many prior cycles, including the more gradual 2004-2006 tightening.
• Starting Point of Inflation: Inflation was significantly higher at the commencement of the 2022 cycle (PCE inflation at 6.77% in March 2022) than it was at the start of the 1994 cycle (around 2.06%) or the 2004 cycle (around 2.89%). This necessitated a more aggressive policy response.
• Unique Global Factors: The inflationary backdrop for the current cycle was shaped by an unprecedented confluence of factors, including post-pandemic supply chain disruptions, significant geopolitical events (such as the war in Ukraine impacting energy and food prices), and massive fiscal stimulus packages deployed during the pandemic.
• Bank Balance Sheet Conditions: Banks entered the 2022 cycle with substantially larger holdings of securities (a result of quantitative easing programmes and surges in deposits during the pandemic) and different funding profiles than they had in 2004. This larger securities portfolio exposed them to greater unrealised losses as rates rose.

While historical episodes offer valuable lessons, the unique confluence of economic, geopolitical, and structural factors in each cycle means that direct “copy-paste” solutions from the past are unlikely to be optimal. A deep understanding of the specific drivers and conditions of the current environment is paramount for effective risk management. Historical analysis should inform the principles of risk management, such as the importance of liquidity, the dangers of excessive leverage, and the need for robust stress testing, rather than prescribe specific tactical responses.

Table 4: Key Historical Rate Hike Episodes & Lessons

Best Practices for Institutional Investors: Synthesising Strategy and Execution

Navigating the complexities of a high-rate environment demands a synthesis of robust strategies and diligent execution. Examining real-world institutional behavior during the recent rate hikes, alongside established best practices, provides a comprehensive framework for CIOs, risk managers, and portfolio managers.

Real-World Institutional Hedging (or Lack Thereof) – The 2022 Experience

The period leading up to and during the 2022 rate hikes offered revealing insights into how different institutional investors managed, or in some cases mismanaged, interest rate risk:

• Bank Hedging Behavior: Research indicates that prior to the 2022 monetary tightening, a significant portion of U.S. banks engaged in surprisingly limited interest rate hedging using derivative instruments. Studies show that only a small percentage of U.S. banking assets (around 6%) were hedged with derivatives, and even banks that were heavier users of such instruments left the majority of their assets unexposed. 

Instead of focusing on hedging the economic market value risk of their assets, many banks turned to accounting classifications. Specifically, there was a substantial reclassification of securities from “Available-for-Sale” (AFS) to “Held-to-Maturity” (HTM). This accounting maneuver allowed banks to shield their book capital and regulatory capital ratios from the immediate impact of falling bond prices caused by rising rates, as HTM securities are carried at amortised cost rather than market value. 

An estimated $1 trillion in securities were reclassified to HTM during this period. Worryingly, this practice was reportedly more prevalent among riskier banks, those with lower capital ratios, higher proportions of uninsured deposits, or longer-duration securities portfolios. Some analyses suggest that these more vulnerable banks not only hedged less but, in some instances, even decreased their existing hedges during the period of monetary tightening. The failure of Silicon Valley Bank (SVB) serves as a stark case study: SVB had hedged approximately 12% of its securities portfolio at the end of 2021, but this figure plummeted to just 0.4% by the end of 2022. 

This behavior, seemingly counterintuitive to standard risk management principles, might be explained by attempts to boost short-term accounting profits by realising gains on profitable hedges (as rates rose) or by a “gambling for resurrection” strategy, where troubled institutions take on more risk. This significant gap between recommended economic hedging practices and the actual behavior of some institutions suggests that regulatory frameworks and accounting rules can sometimes create perverse incentives, potentially overshadowing prudent economic risk management. This implies a continuous need for regulators and accounting standard-setters to consider the systemic implications of such rules and their potential to encourage behavior that might mask underlying economic risks.

• Pension Fund LDI Strategies: Liability-Driven Investment (LDI) strategies, commonly used by defined benefit pension funds to match their long-duration liabilities, also faced significant challenges. The most prominent example was the volatility in the UK gilt market in September 2022. Rapid and sharp increases in gilt yields triggered massive collateral calls on leveraged LDI positions, creating a liquidity squeeze that forced some funds into fire sales of assets and necessitated intervention by the Bank of England. While LDI strategies are designed to hedge long-term interest rate and inflation risk, the UK episode highlighted how such strategies can face acute short-term liquidity risks in highly volatile rate environments, especially when leverage is employed. This underscores the interconnectedness of market risk and liquidity risk and the critical need for LDI managers and pension trustees to conduct rigorous stress testing for liquidity under adverse market conditions, factoring in a wider horizon of extreme but plausible events.
• Asset Manager Commentary (2022-2023): Leading asset managers provided various perspectives during this period.

• • BlackRock noted that rising interest rates and increased volatility could create opportunities for hedge funds, particularly those acting as liquidity providers or employing opportunistic strategies. They emphasised the importance of careful manager selection due to an expected high dispersion in hedge fund returns.
  • J.P. Morgan Asset Management anticipated that market volatility would persist, creating dislocations and unexpected opportunities for alpha generation, particularly for relative value strategies in an inflationary, rising rate environment. They also noted that rising rates could favour shorter-duration value-oriented stocks over growth names.
  • PIMCO, in early 2022, highlighted that short-term yields were becoming more compelling than money market funds and stressed the necessity of active management to both earn attractive yields and defend against risks in a rising rate environment.
  • Vanguard advised investors to maintain a focus on their long-term financial goals, uphold diversification, and avoid making emotional decisions driven by short-term market volatility. The consistent emphasis from various asset managers on active management, opportunistic approaches, and the critical role of manager selection during this period suggests a broader market shift. It implies a move away from passive, set-and-forget strategies, particularly in fixed income, towards approaches where human expertise, adaptability, and the ability to navigate complex market regimes are highly valued. This may lead institutions to reassess their allocation between passive and active management and to enhance their due diligence processes for selecting active managers capable of delivering value in this new environment.

A Framework for Best Practices

Synthesising insights from expert firms like T. Rowe Price and NumberAnalytics, a robust framework for interest rate risk management emerges:

• Comprehensive and Continuous Risk Assessment: Conduct regular, thorough assessments of prevailing market conditions, macroeconomic trends, and the portfolio’s sensitivity to various interest rate scenarios.
• Embrace Active Management: Active management is critical in an uncertain investment environment characterised by potentially higher trend inflation, elevated interest rates, and increased policy uncertainty. This includes active duration management and tactical asset allocation.
• Go Beyond Basic Duration Metrics: While duration is a key starting point, effective management requires looking beyond simple analytical duration. Utilise empirical duration where appropriate, carefully consider the impact of convexity (especially in volatile markets), strategically position exposures along the yield curve, and incorporate country selection in global portfolios.
• Implement Dynamic Hedging Strategies: Employ hedging strategies that can be adjusted in response to changing market conditions and risk assessments, rather than relying on static, one-off hedges.
• Maintain Robust Diversification: Ensure the portfolio is well-diversified across asset classes, geographies, and risk factors to mitigate concentrated risk from any single source.
• Conduct Regular Stress Testing and Scenario Analysis: Perform rigorous stress tests and scenario analyses to understand the portfolio’s resilience under extreme but plausible market conditions, including various interest rate shocks.
• Integrate Quantitative Models: Leverage both traditional quantitative models (such as duration and convexity analysis) and advanced techniques (like Monte Carlo simulations or factor models) for a more robust and nuanced risk assessment.
• Monitor Key Economic Indicators: Stay consistently abreast of economic indicators such as inflation rates, employment data, GDP growth, and central bank communications, as these can signal potential shifts in the interest rate environment.
• Leverage Technology: Adopt advanced analytics and risk management software to enable real-time monitoring, sophisticated modelling, and faster, more informed decision-making.
• Establish Strong Governance: Implement a clear governance structure for risk management. This includes establishing a dedicated risk management committee, formulating a clear risk appetite statement that aligns investment strategies with overall risk tolerance, creating a risk dashboard that aggregates key risk indicators for regular monitoring, investing in continuous training for risk management staff, and regularly reviewing and updating risk management policies.

Integrating Technical Execution with Strategic Oversight

Effective interest rate risk management requires a coordinated effort between different levels of an organisation:

• For CIOs and Senior Executives: The primary focus should be on setting the overall institutional risk appetite and tolerance levels. This involves establishing appropriate governance structures, ensuring adequate resources (including skilled personnel and advanced technological tools) are allocated to the risk management function, and understanding the broad strategic implications of different interest rate scenarios on the institution’s overall objectives, whether it’s meeting pension liabilities, achieving endowment spending rates, or preserving family office capital.
• For Analysts and Portfolio Managers: The focus is on the tactical implementation of the risk management strategy. This includes making dynamic duration adjustments, executing hedging transactions with appropriate instruments, selecting securities that align with the risk strategy, conducting detailed scenario modelling and stress tests, continuously monitoring market signals and risk exposures, and providing timely, data-driven input to inform strategic decision-making at the executive level.

Conclusion: Proactive Risk Management for a Resilient Future

The transition to a higher interest rate environment has fundamentally altered the investment landscape, presenting both significant challenges and new opportunities. The era of persistently low and falling rates, which provided a long-term tailwind for many asset classes, appears to be over. In its place is a more complex and potentially more volatile regime where the active and sophisticated management of interest rate risk is no longer a niche concern but a core strategic imperative for all institutional investors.

Recap of Key Strategies

Effectively navigating this new paradigm requires a multi-faceted approach. The main pillars of robust interest rate risk management discussed in this guide include:

1. Dynamic Duration Management: Moving beyond static duration targets to actively adjust portfolio sensitivity based on evolving rate outlooks, incorporating advanced concepts like empirical duration, convexity, and strategic curve positioning.
2. Sophisticated Hedging: Utilising a range of derivative instruments, such as interest rate swaps, futures, options, and forward rate agreements, to precisely target and mitigate specific rate exposures, tailored to the institution’s risk appetite and market view.
3. Robust Diversification: Expanding diversification efforts beyond traditional asset mixes to include strategies across different yield curves, asset classes with varying rate sensitivities (including real assets and alternatives), and geographic regions, all while understanding the underlying factor exposures.
4. Rigorous Scenario Analysis and Stress Testing: Systematically evaluating portfolio resilience under a variety of adverse interest rate scenarios, including parallel shifts, curve twists, and inversions, to identify vulnerabilities and inform contingency planning.

The Enduring Need for Vigilance and Adaptability

It is crucial to recognise that interest rate risk management is not a one-time exercise or a set-and-forget strategy. Market conditions, economic outlooks, central bank policies, and the characteristics of financial instruments themselves are in a constant state of flux. The financial landscape is inherently dynamic, demanding continuous vigilance, learning, and adaptation from investors and risk managers. The lessons from past rate cycles, while informative, must be applied with a nuanced understanding of the unique drivers of the current environment. Complacency can be costly, and the ability to anticipate and respond to change will be a key differentiator of success.

The overarching message for institutional investors is that complexity in financial markets is on the rise. The “easy money” era, where passive investment strategies often benefited from a secular decline in interest rates, has given way to a period where success will increasingly be defined by sophistication, analytical rigor, adaptability, and a profound understanding of risk in all its dimensions. This implies that the intellectual and operational bar for effective risk management has been significantly raised across the industry.

The Value of Expert Guidance

Navigating this intricate and evolving environment effectively often requires specialised expertise, advanced analytical tools, and deep market knowledge. Implementing sophisticated risk solutions, from quantitative modelling of complex portfolios to the precise execution of derivative hedging strategies and the interpretation of nuanced market signals, can be a formidable challenge for many institutions. A strategic commitment to enhancing in-house risk management capabilities, including investment in talent, technology, and data, is a critical enabler of portfolio resilience and long-term success. In this context, partnering with experienced risk management strategists and consultants can provide institutions with invaluable support, offering the necessary tools, independent insights, and expert guidance to build more resilient portfolios and confidently face the uncertainties of the future financial landscape.