Are there unwanted risks in your savings

Usually this risk is expressed as volatility, which actually means that the future value is uncertain and that actual performance may differ both upwards and downwards from the expected return at the time of the investment. The more risk an investor is willing to take, the greater the potential return. This makes even more sense if you look at it the other way around. The more uncertain the investment, the greater the potential there must be for the investor to be willing to take the risk. This seems both logical and reasonable.

The concept of the "risk-free rate" is used as a benchmark when determining both risk and return. This is the interest rate that could be received by investing your savings as risk-free as possible. In practice this means lending your money to the government with a very short maturity. In this case there is no real counterparty risk because the state is expected to be able to repay its debt (in an absolute worst case by printing new money if the coffers are empty for any reason). In addition, there is no interest-rate risk if you invest your money at a short maturity, and the asset is liquid so if you need you money it is availably practically instantly. This form of investment has therefore historically been the benchmark against which other investments are compared, in terms of both potential return and risk.

The novelty in the above statement is unfortunately close to zero. These are correlations that have been around for a very long time and that form the basis of financial theory. What is new is the fact that this benchmark has now suddenly become negative, which means that if you want to take no risk at all, by this definition you get negative returns on your investment.

Generating a higher return requires some form of risk-taking. This may involve credit risk – that you expose yourself to risk by lending your money to a counterparty that is not as secure as the state. An example would be a company that needs to use the money for investment or an institution that instead finances real estate. You can then obtain a higher return, but at the risk of the full amount not being repaid if the company or institution becomes insolvent. Another option is to lend money for a longer period, at which point you expose yourself to interest-rate risk; if market interest rates were to rise for any reason after you invest, your investment would be revalued using the new rate. This means that the value of your investment falls, before giving a slightly higher return until the instrument matures. When the loan becomes due you will have regained the earlier loss, provided the counterparty has not experienced any problems during the period.

What does this mean in practice?

Suppose that you are a conservative investor, investing in government bonds with a maturity of 10 years to obtain some sort of return now that the short-term risk-free rate has turned negative. Alternatively, you buy a bond fund with a long maturity. You could then receive a return of about 0.8 percent per year over a ten-year period. In ten years, you will have received a total return of just over 8 percent on your capital. Conversely, we can say that you pay today SEK 923 to receive SEK 1,000 in ten years.

But then what happens if market interest rates were to rise after you bought your bond?

If interest rates rise by a modest 0.2 percentage points to a total of 1 percent then you as an investor will lose 2 percent in returns. Your SEK 923 immediately falls to SEK 905. So this means that you will have to wait around two years before re-taking the loss.

What happens if interest rates were to rise to 2 percent?

In this case, you instead lose just over 11 percent of your capital and it will take about 5 years before you regain your capital.

It might sound unlikely that interest rates will rise to 2 percent in the near term, but do not forget that it was less than one year ago that the interest rate was at this level!

After this simplified but, in my view, thought-provoking exercise it may be appropriate to mention that there are alternatives to traditional fixed-income funds with high interest-rate risk. At Catella we offer fixed-income funds that actively work with a flexible approach regarding interest protection. This means that our funds provide better potential returns than traditional fixed income if market interest rates rise.

Our advice to anyone who invests in the fixed-income market or the stock market is to review your risk profile. Be particularly careful in your choice of interest rate products, so you do not take risks that you might not be aware of. The basic rule always applies: If an investor wants higher returns, he or she must be willing to risk something. However, take time to consider whether interest-rate risk is something you are willing to take under current conditions.

IMPORTANT INFORMATION
Past performance is no guarantee of future returns. The money invested in a fund can increase and decrease in value and there is no guarantee that you will get back the full amount invested. No consideration is given to inflation. The funds Catella Balanserad, Catella Credit Opportunity, Catella Fokus, Catella Hedgefond and ICA-fonderna are special funds pursuant to the Swedish Alternative Investment Fund Managers Act (SFS 2013:561) (AIFMA). For a complete prospectus, key investor information, or the annual and half-year reports, please contact us using the details below.