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 As the stimulus is withdrawn, people spend and the savings rate drops so demand should also moderate over time.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

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Retirement

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Shares

On the virtue of owning wonderful businesses like CBA

The US market has pummelled Australia's over the past 16 years and for good reason: it has some incredible businesses. Australia does too, but if you want to enjoy US-type returns, you need to know where to look.

Investment strategies

Why bank hybrids are being priced at a premium

As long as the banks have no desire to pay up for term deposit funding - which looks likely for a while yet - investors will continue to pay a premium for the higher yielding, but riskier hybrid instrument.

Investment strategies

The Magnificent Seven's dominance poses ever-growing risks

The rise of the Magnificent Seven and their large weighting in US indices has led to debate about concentration risk in markets. Whatever your view, the crowding into these stocks poses several challenges for global investors.

Strategy

Wealth is more than a number

Money can bolster our joy in real ways. However, if we relentlessly chase wealth at the expense of other facets of well-being, history and science both teach us that it will lead to a hollowing out of life.

The copper bull market may have years to run

The copper market is barrelling towards a significant deficit and price surge over the next few decades that investors should not discount when looking at the potential for artificial intelligence and renewable energy.

Property

Global REITs are on sale

Global REITs have been out of favour for some time. While office remains a concern, the rest of the sector is in good shape and offers compelling value, with many REITs trading below underlying asset replacement costs.

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.