Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 439

Fixed income solutions in a rising rate environment

The world economy is entering a post-COVID phase but many investors have been caught out by the rise of inflation and the impact on interest rate expectations. In such an environment, it’s vital to have the right fixed income strategy to manage your returns.

The good news is there is a strategy to achieve your income needs no matter what markets are doing, but to get it right we first have to understand the macro environment.

The economic backdrop

We are in for a surge of economic growth as countries exit the more severe impacts of COVID-19 on population mobility. We are watching countries such as the United Kingdom closely as the litmus for how the Omicron strain may impact the recovery. At this stage, it's a case of 'living with the pandemic' even as some restrictions return.

Meanwhile, the surge in economic growth is putting pressure on global supply chains, which were impacted by reduced shipping, manufacturing and uncertain supply and demand expectations. This has combined with an energy shortage in the Northern Hemisphere as it navigates winter.

Markets are concerned inflation will rise higher and stay higher but we see two strong factors at play that should prevent this scenario.

First, supply chain disruptions will be resolved, so supply will grow. Second, demand has been turbo-charged by both higher savings during the pandemic and government stimulus. As the stimulus is withdrawn, people spend and the savings rate drops so demand should also moderate over time.

If we take the global economic barometer as a test case, we see inflation spiking this year at 4.5% in the US but dropping to 3% next year.

How will this impact interest rates?

In Australia, the interest rate mantra of the Reserve Bank of Australia since the pandemic began has been ‘lower for longer’. As we progressed through 2021 the term was dropped from the RBA lexicon.

That slogan is adapting to the changing environment, and the RBA has accepted that the ‘transitory’ inflation from supply chain disruptions is more entrenched than previously expected. The first rate hike will likely occur sometime in 2023 instead of the previous guidance of 2024.

In the US we expect rates to move higher more rapidly. We expect the Federal Reserve to trigger its first rate rise in June 2022 and increase by 0.75% by year end. The Fed will ween the economy off artificially-induced monetary and fiscal stimulus.

The disparity between Australian and US interest rates will likely be created will make US-denominated fixed income an attractive alternative to local offerings, although our diversification model for portfolio construction prefers a mix of local and international offerings.

With rates re-pricing, the attractiveness of corporate bonds is improving, but of course, as interest rates rise, fixed rate bond prices fall. This creates more of an issue for the duration of fixed income instruments held, as the underlying reason to invest in fixed income to generate regular and stable cash flow remains the same.

Strategies to pursue

We expect the interest rate outlook could push US 10-year Treasuries out to 1.5-2% in 2022, and cash remains unattractive even in a rising rate environment. Longer duration fixed income instruments could also face issue price deterioration, but not all bonds are created equal and there are high-value alternatives.

We have turned our attention to suitably-positioned hybrids, which offer attractive yields, portfolio protection against rising rates and significantly less volatility than shares.

Hybrids are fixed income structures that contain characteristics of both debt and equity. Some can be traded on the ASX but we prefer the deeper liquidity found in the OTC (over-the-counter) market.

They do, however, have terms and conditions that can be specific for each issue, and carry risks different to both bonds and equities.

How can hybrids help reduce a portfolio’s sensitivity to interest rates?

Hybrids often have a call option whereby the company will effectively buyback the issue to take advantage of another opportunity to manage the debt side of its balance sheet. That opportunity may be another hybrid issue on terms the company expects will include benefits for it. These call options have created a perception that hybrids are a short- to medium-term investment with low sensitivity to interest rates.

A floating rate may have more emphasis for those seeking USD hybrids as the Federal Reserve is expected to have a more aggressive path for interest rate rises, whereas the RBA is expected to move more slowly, giving greater weight to fixed coupons (usually confined to the OTC market).

For variable coupons, if the bond is not called at the call date, the coupon may be reset to a benchmark rate. This reset may allow investors to take advantage of higher rates.

All these variations and differences in terms and conditions can make hybrids seem complex, but it’s more about determining the macro factors you expect going forward and choosing the instrument that best meets those outcomes.

What are the advantages of hybrids in a portfolio?

For income seeking investors:

  • Potential for predictable and regular income stream (fixed or floating).
  • Potential to receive interest payments over long periods of time.
  • Interest payments on hybrids are generally higher than for senior debt (corporate bonds).
  • Issuers may also have a step up in coupons paid over the lifetime of the bond.
  • Hybrids can enhance returns to core bonds with additional risks or reduce volatility of stock portfolios.
  • Hybrid issuers often have high-quality financial profiles and are generally rated Investment Grade.
  • Hybrids also enable investors to diversify their portfolios across regions, industries, and sectors.
  • Global over the counter (OTC) hybrids are a larger and more liquid market than ASX-listed hybrid offerings. Investors with access a range of international hybrids, included those issued by well-recognised global European banks or leading US blue chip companies.

What we like in the current settings

We currently like hybrids issued from leading global banks. Unlike in the GFC that saw a seizure of liquidity and credit markets, high quality banks are in better position today than they were 12 years ago.

There is continued improvement in the US and European financial system stability as banks benefit from lower regulatory and borrowing costs. Opportunities exist in high quality European banks hybrids that offer yield pick-up to US Financials and are showing ratings resilience due to generally strong capital and liquidity positions, as well as extraordinary support measures in place from government and regulators.

Banks continue to exhibit strong earnings for 2021, bolstered by super charged investment banking revenues and lower provisions for bad debt, the latter providing greater confidence to view a wider variety of opportunities on the risk spectrum.

We are finding more comfort in extending both duration risk and moving down the capital structure for these bonds.

Examples of our top picks (as at December 2021):

  • USD: Macquarie Bank London 6.125% perpetual is paying a 4.6% yield and with the first callable date in 2027.
  • USD: Vodafone 3.25% 2081 with a first call date in 2026. Low minimum denomination of US$50,000.
  • Investors can also invest in the property market through fixed income products. Scentre Group hybrid pays a coupon of 5.125% maturing in 2080. Hybrids can be bought and sold every day, investors are not locked in for long periods, they can benefit from the high income and sell the bond any time before maturity.

These hybrids also have variable coupons - if they are not called by the issuer at the next callable date, the coupons will be reset on a benchmark rate plus a spread. Investors who expect rates to go higher can therefore benefit from higher coupon rates.

 

Elsa Ouattara is the Fixed Income Investment Lead for Citi, a sponsor of Firstlinks. Information contained in this article is general in nature and does not take into account your personal situation. Please note that some of the investments mentioned in this article are only available to 'sophisticated' investors and are not listed on the ASX or Chi-X in Australia.

For other articles by Citi, see here.

 

1 Comments
N Mohanty
January 18, 2022

This blog post is really helpful. Thanks for sharing!

 

Leave a Comment:

RELATED ARTICLES

Red pill or blue pill? Navigating the matrix of fixed income

Fixed income investing when rates are rising

Why bank hybrids are being priced at a premium

banner

Most viewed in recent weeks

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

The catalyst for a LICs rebound

The discounts on listed investment vehicles are at historically wide levels. There are lots of reasons given, including size and liquidity, yet there's a better explanation for the discounts, and why a rebound may be near.

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

How not to run out of money in retirement

The life expectancy tables used throughout the financial advice and retirement industry have issues and you need to prepare for the possibility of living a lot longer than you might have thought. Plan accordingly.

Latest Updates

Investment strategies

Investors are threading the eye of the needle

As investors cram into ever narrower areas of the market with increasingly high valuations, Martin Conlon from Schroders says that sensible investing has rarely been such an uncrowded trade.

Economy

New research shows diverging economic impacts of climate change

There is universal consensus that the Earth is experiencing climate change. Yet there is far more debate about how this will impact different economies across the globe. New research sheds more light on the winners and losers.

SMSF strategies

How super members can avoid missing out on tax deductions

Claiming a tax deduction for personal super contributions can end in disappointment if it isn't done correctly. Julie Steed looks at common pitfalls and what is required for a successful claim.

Investment strategies

AI is not an over-hyped fad – but a killer app might be years away

The AI investment trend looks set to continue for years but there is only room for a handful of long-term winners. Dr Kevin Hebner also warns regulators against strangling innovation in the sector before society reaps the benefits.

Retirement

Why certainty is so important in retirement

Retirement is a time of great excitement but it is also one of uncertainty. This is hardly surprising given the daunting move from receiving a steady outcome to relying on savings and investments.

Investment strategies

Have value investors been hindered by this quirk of accounting?

Investments in intangible assets are as crucial to many companies as investments in capital equipment. The different accounting treatment of these investments, however, weighs on reported earnings and could render ratios like P/E less useful for investors.

Economy

This vital yet "forgotten" indicator of inflation holds good news

Financial commentators seem to have forgotten the leading cause of inflation: growth in the supply of money. Warren Bird explains the link and explores where it suggests inflation is headed.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.