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 As the stimulus is withdrawn, people spend and the savings rate drops so demand should also moderate over time.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.
- AUD: A perpetual issue by Societe Generale with a first call date in 2024. If the call option is taken, it is an investment under 3 years with a coupon of 4.875% a year and relatively low sensitivity to interest rates.
- 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 four 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.
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