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Fixed income solutions in a rising rate environment
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Fixed income solutions in a rising rate environment

The global economy is now in a post-COVID phase, but many investors are being caught by the rising inflation and its impact on interest rates expectations. It is crucial to have the right fixed income strategy in order to manage your returns in such a setting.

The good news is that there is a strategy for achieving your income needs regardless of the market. However, to do it correctly we must first understand the macro environment.

The economic background

As countries leave the more severe COVID-19 impacts on population mobility, we can expect a surge in economic growth. We are monitoring the United Kingdom closely to see how the Omicron strain may impact recovery. At this point, it’s all about ‘living in the pandemic’ while some restrictions return.

The surge in economic growth is putting stress on global supply chains. These were impacted due to reduced shipping, manufacturing, uncertain supply and demand, and reduced shipping. This has led to a winter energy crisis in the Northern Hemisphere.

Markets are worried that inflation will rise and stay higher, but we see two strong forces at work that should stop this.

First, supply chain disruptions can be resolved so that supply will grow. The government stimulus and higher savings have also boosted demand. As stimulus is withdrawn people spend more and the savings rate falls so demand should moderate over time.

As a test case, the global economic barometer shows that inflation will spike this year at 4.5% US and drop to 3% next.

How will this affect interest rates?

Since the pandemic, the interest rates of the Reserve Bank of Australia have been lower for a longer time in Australia. As we moved through 2021, the term was dropped by the RBA.

The RBA has acknowledged that the temporary inflation caused by supply chain disruptions is more deeply embedded than originally thought. The new guidance for 2024 suggests that the first rate hike will occur in 2023.

We expect the US to see rates rise faster than usual. We expect the Federal Reserve’s first rate rise to occur in June 2022. It will then increase by 0.75% at year’s end. The Fed will reduce artificially-induced monetary and fiscal stimulus to the economy.

The likely disparity between US and Australian interest rates will make US-denominated fixed Income an attractive alternative to local offerings. However, our diversification model for portfolio building prefers a mix local and international offerings.

The attractiveness of corporate bonds is increasing due to a re-pricing of rates. However, fixed rate bond prices will fall as interest rates rise. This makes it more difficult to hold fixed income instruments for a longer period of time, since the main reason to invest is to generate steady and consistent cash flow.

Strategies to pursue

We anticipate that the interest rate outlook could push US 10-year Treasuries to 1.5-2% by 2022. Cash is still unattractive, even in a rising rate environment. But not all bonds can be equal and there are many high-value alternatives.

We are now focusing our attention on hybrids that are well-positioned, which offer attractive yields and portfolio protection against rising rates, as well as significantly less volatility than shares.

Hybrids can be fixed income structures with both equity and debt characteristics. Some can trade on the ASX, but we prefer deeper liquidity in the OTC market (over-the counter).

They can have terms that are specific to each issue and carry different risks from equities and bonds.

How can hybrids reduce the sensitivity of portfolios to interest rates?

Hybrids often offer a call option that allows the company to buy back the issue in order to take advantage of another opportunity for managing its debt side. The company may offer another hybrid issue to take advantage of another opportunity to manage its debt side.

A floating rate may be more important for those looking for USD hybrids. The Federal Reserve is expected have a more aggressive path to interest rate rises. The RBA, on the other hand, is expected to move slower and give more weight to fixed coupons (usually limited to the OTC market).

Variable coupons can be reset to a benchmark interest rate if the bond has not been called by the due date. Investors may be able to take advantage higher rates by having the coupon reset.

Hybrids can be confusing because of the many variations and differences between terms and conditions. However, it is more about determining the macro factors that you expect to happen in the future and choosing the instrument that will best meet those outcomes.

What are the benefits of hybrids in a portfolio.

For income seeking investors:

  • Potential for regular and predictable income stream (fixed, floating).
  • Potential to receive interest payments for long periods.
  • Hybrids pay more interest than senior debt (corporate bond) in general.
  • Additionally, issuers might receive a step-up in coupon payments over the life of the bond.
  • Hybrids can increase returns on core bonds while taking on additional risks or reducing volatility in stock portfolios.
  • Hybrid issuers have often high-quality financial profile and are generally rated Investment Quality.
  • Hybrids allow investors to diversify across regions, industries, or sectors.
  • Global over-the-counter (OTC) hybrids offer a more liquid and larger market than ASX-listed hybrid offerings. Investors have access to a variety of international hybrids, including those issued by leading US blue-chip companies or well-respected global European banks.

What we like about the current setting

Hybrids from top global banks are currently our favorite. High quality banks are better than 12 years ago, unlike the GFC which saw a seizure liquidity and credit markets.

As banks have lower borrowing and regulatory costs, there is a steady improvement in the stability of the US and European financial systems. There are opportunities in high-quality European banks hybrids that offer yield pickup to US Financials. They also show ratings resilience due generally strong capital and liquidity positions as well as extraordinary support from regulators and government.

Banks are expected to continue to post strong earnings for 2021. These results were aided by super-charged investment banking revenues and lower provisions to bad debt. The former gives banks more confidence to view a wider range risk opportunities.

We are finding greater comfort in extending both the duration risk of these bonds and in moving down their capital structure.

Here are some examples of our top picks as of December 2021

  • USD: Macquarie Bank London 6.125% perpetual pays a 4.6% yield with the first callable date being 2027.
  • USD: Vodafone 3.25% 2081, with a first calling date in 2026. Minimum denomination: US$50,000
  • AUD: A perpetual issue of Societe Generale, with a first call date of 2024. If the call option is chosen, it is an investment of less than 3 years with a coupon rate of 4.875% per annum and a relatively low sensitivity for interest rates.
  • Fixed income products allow investors to invest in the property market. Scentre Group hybrids pay a coupon of 5.125% that matures in 2080. Hybrids can easily be bought and sold every single day. Investors are not locked into long periods and can take advantage of the high income or sell the bond anytime before maturity.

These four hybrids also come with variable coupons. If they are not called at the next callable date by the issuer, the coupons will reset on a benchmark rate plus spread. Higher coupon rates can be a benefit to investors who expect rates will rise.

Elsa Ouattara serves as the Fixed Income Investment Lead CitiFirstlinks sponsors -. The information in this article is general and does not reflect your personal situation. Please note that some investments in this article are only available for’sophisticated investors’ and are not listed on Australia’s ASX or Chi-X.

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