As central banks begin the final stages of unwinding ultra-loose monetary policies, we look at the trading implications and how to best position portfolios.
Background
The year ahead should herald a return to more normalised monetary policies following unprecedented stimulus programs since the onset of the pandemic. Central banks will need to find the right balance in unwinding accommodative policies to avoid a nasty reaction from global markets.
In anticipation of central banks hiking rates, ending bond purchases, and shrinking balance sheets, short- and longer-term yields have moved higher, as markets reprice for the tightening cycle.
Domestically, markets have priced in four rate hikes for 2022 following the Reserve Bank of Australia’s (RBA) February meeting, whereas the RBA maintains it is ‘prepared to be patient’. The Australian central bank has been more dovish compared to peers, waiting for wage growth to support what is currently subdued inflation by global standards. Despite the recent uptick in inflation for 4Q21 to 2.60%, the RBA has stated it will not increase the cash rate until actual inflation is ‘sustainably within the 2%-3% target band’.
Meanwhile, the US Federal Reserve (Fed), is tasked with reducing higher inflation and are set to pull the tightening levers. At its last meeting it signalled a rate hike in March when it will simultaneously end its bond purchases, before looking to reduce its asset holdings. Markets are also pricing in an additional five rate hikes beyond this initial move.
With a hawkish US Fed, it remains to be seen if the RBA sticks to its guns or will have its hand forced by other central banks to move faster. In its December meeting minutes, the RBA flagged it would consider the ‘actions of other central banks’ in its own decision making.
Against this backdrop, we believe there are key considerations and opportunities for fixed income portfolios. Despite the rising rate environment, we see opportunities to add longer dated fixed coupon bonds and favour higher margin floating rate notes. Meanwhile expect some volatility as rates rise, which will create ideal trading conditions to add higher yielding bonds from issuers with lower leverage.
Once again, diversification is key, along with a laddered portfolio across maturities to help mitigate rising yield curves and what is likely to be an ongoing interest rate reset (up and then potentially down) over the medium term.
Investment grade allocations
We consider investment grade bonds a core portfolio holding and see opportunities to add longer dated fixed coupon investment grade issues. This may seem counterintuitive in a rate hiking environment, where the capital price on longer dated investment grade bonds is negatively impacted by moves higher in the Government yield curve.
However, moves in longer dated yields have already taken place as the market repriced for the current rate hike cycle, as the chart below shows. The 10-year Australian Commonwealth Government Bond (ACGB) yield spiked over 40 basis points (bps) in the past month, currently sitting about 16bps above the 10-year US Treasury bond yield. This is despite the RBA remaining dovish and only recently discussed a possible rate hike in late 2022, against a US Fed that has openly turned aggressive in its tightening approach.
With yields unlikely to move materially higher, we believe there is an attractive opportunity to add longer dated fixed coupon bonds to portfolios. With inflation dynamics domestically very different compared to the US, it is unlikely the RBA will follow the same path as the Fed and current pricing for rate hikes in Australia may be premature. If this is the case, we would expect to see the yield curve flatten as it readjusts to a slower path to rate hikes from the RBA.
While yields have pushed higher, credit spreads have widened recently as illustrated in the following chart. The Ausbond Credit Index, a composite of investment grade bonds, shows the move in credit spreads (the risk premium over the risk-free rate) widening over 20bps since October last year. Keeping in mind, a widening in credit spreads generally translates to capital price weakness, and the converse is true where there is credit spread tightening.
With a more progressive tightening approach from the RBA, we do not believe the current widening trend in spreads is sustainable and will revert. As spreads compress from recent moves, it will offset any marginal moves higher in the yield curve, somewhat softening capital price movements.
When selecting longer dated fixed coupon bonds, it’s worth looking for issues paying a higher coupon (look for out of favour issuers, sectors etc that issued wider to peers) that will provide a higher income stream and a buffer for any potential capital price movement.
Investment grade allocations
Traditionally in tightening cycles, floating rate note exposures provide some capital price protection together with running yield upside, as the coupons will increase with an uplift in the 3M Bank Bill Swap Rate (BBSW). Floating rate notes are a key part of any fixed income portfolio, however in the current hiking cycle we favour floating notes offering higher margins.
The 3M BBSW has been stuck at historic lows (trading in a range of 0.06% to 0.22% last year), closely aligned to the cash rate and interest rate views. As the RBA maintains a dovish approach, the 3M BBSW although having moved higher remains relatively low (at 0.07% at time of writing), meaning there is limited benefit to the income from low margin floating rate notes.
Currently, the forward-looking 3M BBSW is expected to reach 0.76% in six months’ time, and 1.50% in a year’s time. As such, higher margin floating rate notes will provide better returns in the near term until the RBA is further into its rate hiking cycle, pushing the 3M BBSW higher.
In selecting higher margin floating rate notes, we see value in unrated exposures, as well as those further down the capital structure issued by quality issuers. Floating rate notes offer a dual purpose in portfolios in a rate hiking environment and with the coupon resetting every three months, there is limited interest rate risk and generally less capital price movement. This provides better liquidity compared to other types of instruments.
Additional floating rate instruments offering a higher margin include Residential Mortgage-Backed Securities (RMBS) and Asset Backed Securities (ABS). We believe the year ahead will see a spike in new issuance compared to 2021 as banks should return to the primary market, having relied on the RBA’s Term Funding Facility (TFF) in the last couple of years.
High yield exposures
As the era of ultra-loose monetary policy comes to an end, we favour taking a more cautious approach when selecting higher yielding exposures. As cheap debt matures, highly leveraged issuers may face refinance risk, where they may be unable to service debt issued at higher rates. When selecting high yield exposures, it’s worth considering shorter dated exposures, where there is less outstanding debt due to mature prior.
We also believe periods of volatility and spread widening will create opportunities to add high yield bonds at improved entry points. Windows of spread widening should recover relatively quickly, as we saw across the last year, shown in the chart below of the Solactive FIIG Australian High Yield Index. The Index, made up of 38 unrated issues, shows short periods of weakness quickly followed by a trend higher.
A theme we have previously discussed and continue to see value in is moving down the capital structure of quality issuers. Better returns can be achieved by taking incremental credit risk which can be achieved by investing in junior ranking securities issued by larger investment grade rated companies.
We see value in Corporate Hybrids and Tier 1 Capital instruments. Each have their own features that investors should be aware of prior to investing.
Diversification
As central banks navigate through the final stages of unwinding their unprecedented stimulus measures, a diversified portfolio remains key no matter what the exit path entails. The fixed income asset class will smooth out volatility that is expected in equity markets until rate timing becomes more certain.
In regard to fixed income portfolios, we believe a staggered maturity profile will help mitigate a rising yield curve, protecting against short- and longer-end repricing moves. In diversifying across a layered maturity profile, a portfolio is better constructed to spread the risk across the interest rate curve.
FIIG’s retail clients will also have a better level of diversification available compared to previously, as a result of significant increases in the number of bonds that have been made available as part of the wider Retail Offering. Likewise, wholesale portfolios will benefit from the Smaller Parcel Trading service, where portfolios can hold smaller exposures of particular bonds that previously were only available in larger parcels.
Constructing a well-diversified portfolio, with a laddered maturity profile will remain key for investors no matter what unfolds over the year ahead.