As inflation ticks up and with it, interest rates, investors would do well to look at floating rate instruments….

Pieter Staelens, Portfolio Manager
CVC Income and Growth

So we’re looking at the first UK interest rate rise since 2023. With inflation reaching 3.5% in September against the Bank of England’s 2% target, rates have risen by 25 bps to 4% as the Bank attempts to prevent second round inflation from higher wage demand, high business prices and higher services inflation. 

This rise symbolises that the Bank is concerned about inflation becoming embedded in the economy, rather than being a temporary energy price shock and a reaction to the ongoing unrest in the Middle East, the war in Ukraine and disrupted global energy supplies. 

What’s more uncertain is the direction of the subsequent rate path. Reuters has reported that markets are pricing in a potential further three to four 25bp increases in 2027, taking the rate closer to 5%. But many expect that weak economic growth will prove to be a natural deflationary factor, in which case the Bank of England would pause further increases. Time will tell. 

As this uncertain interest rate environment prevails, it would be worth investors looking at floating rate investments (like loans) where the interest income you receive moves up or down in line with market interest rates, unlike bonds which are fixed. They are attractive in volatile environments for a few good reasons:

• Interest rate uncertainty protection: unlike fixed rate bonds, floating rate instruments re-set their interest payments periodically (e.g. every three months) based on a benchmark like SONIA. So if interest rates stay higher for longer, or rise again, investors benefit from higher income and aren’t locked into a lower fixed rate.
• Reduced rate risk: floating rate instruments tend to have low duration, so their prices are much less sensitive to changes in interest rates. In a market where there is a lot of uncertainty around central bank monetary policy, the stability from floating rate instruments is compelling.
• Potential for higher income: because base rates have been elevated, the yield on floating rate instruments is relatively high. So investors can effectively capture today’s higher rates without betting on where rates go next. Floating rate loans typically pay interest 3-4% above the respective central bank base rates. As interest rates move higher, the yield on the loans increases.
• Inflation resilience: floating rate instruments can give you some protection to inflation, to a degree. If inflation is sticky and keeps rates higher, floating rate coupons adjust upwards. That gives them a degree of protection compared to fixed income streams that get eroded in real terms.

So floating rate instruments are appealing at the moment because they offer high income, plus flexibility and protection against rate volatility and inflation to an extent. 

These characteristics may be attractive to some investors in an uncertain ‘higher for longer’ rate environment.

For information purposes only. Not investment advice or a recommendation to invest. Past performance is not a reliable indicator of future results. Capital is at risk. UK investors only.