As investors seek ways to position their liquid credit portfolios for rising rates and inflation, options include floating-rate products, duration-controlled strategies and shorter-duration fixed rate assets.
Fixed income buyers need to consider these against the backdrop of an environment that is displaying similarities with what has been seen in past cycles.
For example, said Martin Horne, head of global public fixed income at Barings, rising inflation and the potential for further rates hikes are positioned amid an economy in reasonable shape, as has been the case historically when at the early stages of rate-hiking cycles.
Yet he also cited some unique elements today – mostly related to the underlying causes of the inflation. “Energy is clearly undergoing significant structural changes, accelerated by climate policy and the movement toward renewables, and prices have risen as a result,” said Horne.
This has been further exacerbated by Russia’s invasion of Ukraine, with oil prices recently reaching multi-year highs and Brent crude surpassing $100 barrel for the first time since 2014. Supply chain disruption amid ongoing Covid-19 flare-ups around the world is another contributing factor, he added.
Adapting fixed income allocations
For investors looking to navigate the next couple of years, Horne outlines several options in a rising-rate environment.
Among them are floating-rate products – the most obvious of which include straightforward floating-rate and inflation-linked products, from treasury inflation-protected securities (TIPS) to pure floating-rate corporate loans, both public and private.
“Loans, in addition to providing a hedge against rising rates, offer credit risk protection through capital
structure seniority and security in the form of asset-backing and covenant restrictions. Because loans are secured by collateral, they have also historically offered high recovery rates relative to other fixed income asset classes,” explained Horne.
In addition, the collateralised loan obligation (CLO) market offers a range of opportunities across the capital structure. With floating-rate coupons, CLO prices have historically been stable in rising-rate environments relative to fixed rate asset classes like high yield or investment-grade corporate bonds, he added.
Duration-controlled or short-duration strategies are another option for investors, which could be emerging or developed market, with different collateral mixes involved.
“Short-dated bonds have lower duration risk, which means the price of the bond is fundamentally less sensitive to changes in interest rates compared with longer-dated bonds,” said Horne.
However, he added that credit selection matters and will continue to be a big differentiator in performance, helping to identify the issuers that can withstand any forthcoming uncertainty.
Further, shorter-duration fixed rate assets such as global high yield bonds, for instance, have duration of roughly 3.82 years, compared with 7.04 years for investment-grade corporate bonds.
“As a result, even in periods of rapidly rising US treasury yields/interest rates, high yield returns have only been marginally impacted, while longer duration asset classes have tended to sell-off more aggressively,” explained Horne.
A close watch on the near future
For the next 12 to 24 months, a key macro factor to watch will include the war between Russia and Ukraine and the subsequent uncertainty across markets. At the same time, events in China may lead to further bouts of volatility this year.
For fixed income investors in particular, Horne sees central banks and inflation as areas to monitor closely. “To use a somewhat exhausted metaphor, we’re in uncharted territory today given the size of the potential tapering programmes and the nature of the inflationary conditions we’re facing.”
He believes that as central banks react in this environment and markets respond to new data points suggesting the policies being enacted are having positive or negative effects, volatility is very likely.
“Periods of uncertainty and volatility are the moments when active asset selectors should really shine,” said Horne.
His view is that certain fixed rate assets have been “beaten up quite a bit, perhaps too much”, given the combination of a positive fundamental backdrop and strong refinancing and M&A activity.
As a result, for fundamental buyers able to pick their positions in pursuit of the best value, these conditions can result in opportunities to pick up significant premiums. “Given the volatility we expect to continue to see this year, I think we may see some of the best asset selection opportunities we’ve seen in a while,” he added.
