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11 Nov 2021

Fixed Income solutions in a rising rate environment

By Elsa Ouattara, fixed income investment research lead Inflation is on the rise and and interest rates are prepped to come off historic lows. We examine strategies to maintain the income side of your portfolio

It’s evident the world economy is entering a post-COVID phase but most have been caught out by the rise of inflation and the impact this has had on interest rate expectations. As we look towards a rising yield environment it’s vital you 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

The immediate economic news is that we are in for a surge of economic growth as countries exit the more severe impacts of COVID-19 on population mobility.

This 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 heads into winter and caused a resurgence in inflation pressure.

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 As the stimulus is withdrawn, people spend and the savings rate drops, so demand should also moderate.

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

However, in its November statement on monetary policy the RBA accepted that the ‘transitory’ inflation being experienced from supply chains disruptions is more entrenched than previously expected, even if it is not as strongly felt as in the US, and that the first rate hike to bring the official interest rate off its historic low of 0.25 per cent would likely occur sometime in 2023, instead of the previous guidance of 2024.

Our overall view on wage growth and inflation point to the first rate hike in early 2023. In the US we expect rates to move higher more rapidly. We expect the Federal Reserve to trigger its first rate rise in June next year and increase rates by 0.75 per cent by year end. This will occur as the Fed navigates its telegraphed road map for weening the economy off artificially induced monetary and fiscal stimulus. A similar process has begun in Australia.

The disparity between Australian and US interest rates that will likely be created may 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 becoming more attractive, but we also have to face the reality of the bond market – that is, as interest rates rise bond prices fall. This creates more of an issue for the duration of fixed income instrument 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 per cent this year, so cash remains unattractive even in a rising rate environment.

Longer duration fixed income instruments could also face issues price deterioration, but not all bonds are created equal and there are high-value alternatives.

In this environment we have turned our attention to suitably positioned hybrids, which offer attractive yields, the potential for less sensitivity to interest rate movements, and significantly less volatility than shares.

Hybrids are simply fixed income structures that contain elements 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. To understand the risks, please talk to your relationship manager. Some key considerations for hybrids include:

  • Have risks similar to equity investments.
  • May convert into ordinary shares.
  • Potential to be written off if the issuer experiences financial problems.
  • May contain terms and conditions that allow the issuer to suspend interest payments or exit when they choose.

 

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

Hybrids often have a call feature 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 well be another hybrid issue on terms the company expects will have benefits for it.

As these call features are often taken advantage of, it has created a perception that hybrids are a short to medium term investment with low sensitivity to interest rates - as they don’t have the exposure to greater uncertainty that may impact long-dated instruments.

Hybrids can have either a fixed interest rate for periodic payments or some have a floating rate and others a variable rate. A floating rate may have more emphasis for those seeking USD hybrids in the current economic setting as the Federal Reserve is expected to have a more aggressive path for interest rate rises, whereas the Reserve Bank of Australia is expected to move more slowly, giving greater weight to fixed coupons.

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 (the risk you carry is issuer default).
  • 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 (if not impacted by any triggered call provisions).
  • 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 Citi can access hybrids issued by well-recognised global European banks or leading US blue chip companies.
  • It should also be remembered that hybrids can be bought and sold, so investors need not be locked in for long periods, they can benefit from the high income and sell the bond anytime before maturity.

 

What we like in the current settings

We currently like hybrids issued from leading global banks. Unlike the 2008 global financial crisis (GFC) that saw a seizure of liquidity and credit markets, high quality financials 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, and therefore 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 of 21 October 2021

  • USD: Macquarie Bank London 6.125 perpetual note is paying a 4.2% yield and has its first call date in 2027.
  • USD: Vodafone’s long-dated 2081 offering carries a 3.25% coupon with a first call date in 2026. With a low minimum denomination of $USD50,000 it may be of interest to investors with investment size constraints.
  • AUD: A perpetual issue by Societe Generale with a first call date in 2024. If SG calls the security it will stand out as an investment of under three years with an annual coupon of 4.875% and relatively low sensitivity to interest rates.
  • USD: Investors can also invest in the property market through fixed income products. Scentre Group has a 2080 maturity issue that is paying a coupon of 5.125% and has a first call date of 2030.

These 4 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.

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