What's a fixed-income investor to do?
As rates rise, look for opportunities on the shorter end.
With inflation hanging around multi-decade highs and yields continuing to climb across the curve, what’s a fixed-income investor to do? The short answer is to, well, think short.
That is, consider shorter-term instruments where the income benefit from higher yields can help offset the damage from the corresponding decline in prices. These may include high-yield securities, where duration—a bond’s sensitivity to changes in interest rates—runs about half that of investment-grade corporate bonds. Or asset-backed securities (ABS), which typically have very short maturities and are tied to parts of the economy such as autos and credit cards that are doing well amid rising incomes and flush savings. When the economy is strong, high yield and ABS typically hold up, bolstered by solid credit conditions and relatively low defaults.
Other shorter-term fixed-income assets that tend to benefit when rates are rising and the economy is healthy include such specialized areas as trade finance, bank loans and other floating-rate securities. Take trade finance. True, supply chains remain an issue. But that’s in part because global trade is booming as economies reopen and consumers load up on goods—December U.S. exports and imports hit record highs. This is a tailor-made environment for trade-finance loans that provide short-term financing to support the flow of goods between buyers and sellers, with the goods themselves—not the companies or countries—typically serving as collateral for the loans.
Is ‘3-6-3’ making a comeback?
It may not be a return to the “3-6-3” days for bankers (gather deposits at 3%, lend at 6% and hit the golf course at 3 p.m.), but the breakout in yields promises better times. With deposit rates still stuck at historic lows (if you have an interest-bearing checking account, you know what I mean), rising yields have banks opening the spigots. The Fed’s Q1 2022 Senior Loan Officer Survey showed banks easing lending standards across a variety of loan types, including residential mortgages and auto loans, as well as strengthening demand for commercial real estate and commercial and industrial loans. With still easy financial conditions and expected above-trend GDP growth this year, trade finance and bank loans are just two types of floating-rate securities whose rates “float,” i.e., rise and fall, with market rates, offering opportunities in this rising-rate cycle.
As we look ahead, there are many reasons to think the low and stable inflation we’ve come to know over the past few decades is coming to end. Among them, working age populations are or soon will be declining in many developed markets and China, health-care costs are almost certain to keep rising as the world gets older and climate change initiatives all over the globe will require massive costly investments. This suggests the terminal rate—the stopping point in the Fed’s hiking cycle—could well top the nearly 2% markets are currently pricing in and that yield increases have a ways to go. This makes rate strategies—not just yield curve and duration positioning but also security selection among assets that can benefit from rising rates—a dominant theme when it comes to fixed-income investing this year.