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Fixed income is not dead: Why you should look at your exposure differently

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This is a sponsored article from Union Bancaire Privée’s asset management business.

The current environment is one where higher beta credit segments with a low sensitivity to US rates can outperform and where credit compression can also take place. High Yield spreads should benefit from the ongoing recovery and low default rates, whilst Additional Tier (AT1) debt provides an attractive opportunity thanks to the strong fundamentals of the banking sector and resilient earnings throughout the pandemic.

Where are today’s market opportunities in fixed income?

By Olivier Debat, Senior investment specialist, UBP
We continue to see the current macroeconomic environment as positive for credit, as we do not anticipate any aggressive tightening in financial conditions. Although we still expect real rates to rise, they are going up from historically depressed levels and so should not be disruptive for risk assets. In addition, with central banks attempting to lift rates for the first time in many years, they are incentivised to do so in a smooth manner to allow them to raise rates high enough to provide room to cut them again in a future downturn.

We see the current backdrop as positive for credit from a bottom-up perspective, due to impressive and improving credit fundamentals, following strong earnings growth in 2021 with prudent balance sheet management. The net leverage for US Investment Grade names has fully reversed the increase observed during the pandemic, whilst a US HY default rate of under 1% for 2021 highlights how this segment of the market has benefitted from the reopening of economies. Default rates are also expected to stay low in 2022. Although there are plenty of concerns around inflation, our own analysis indicates that some inflation, if not too high, is good for corporates – notably for banks.

In 2022, we see opportunities in defensive floating rate notes and high beta credit. First, Floating Rates Notes (FRN): they will benefit from the new Fed hiking cycle. The market is now anticipating four rate hikes in 2022 (and three more in 2023). A portfolio of short-dated investment grade FRN can be used as an alternative to cash. The 12-month forward yield of such a portfolio is currently 1.8% with no downside risk from rising interest rates. Second, high beta credit with a limited exposure to interest rates. We like a global high yield portfolio built with CDS indices. The benefit for investors is that they can keep a full exposure to high-yield spreads while maintaining a limited interest rate exposure of, say, 1.5 years. The current yield of such a portfolio is 5.0% and this strategy delivered +20% during the previous Fed rate hike cycle. Finally, we like subordinated debt of systemic European banks (AT1). Bank margins benefit from higher interest rates and the asset class structurally has a moderate interest rate duration of around three years. AT1 spreads still trade above their pre-Covid-19 levels by around +50 bps.

How an investor should think about fixed income exposures

By Francis Wong, Head of Business Development, Greater China and Southeast Asia, UBP
We get this question from our clients constantly. How can I better position my fixed income strategy in light of the imminent tapering and potential rate hikes in 2022? As fixed income has been an integral part of investors’ portfolios, now is the time to reposition the fixed income exposure with a dynamic approach.

Source(s): UBP, Bloomberg Finance L.P., as at 06 January 2022. FWCM US Treasury curve. Past performance is not a guide to current or future performance.

An investor should seek exposure to the higher return potential of global high yield credits, while maintaining ample liquidity, broad diversification and a very low exposure to interest rates. This can be achieved by focusing on the use of CDS indices where investors can potentially achieve a higher return with low duration exposure, compared to cash-bonds. The CDS indices have been able to withstand the market volatility led by interest rates in 2021, and it is conceivable that the same can be replicated in 2022.

Another way to think about this is to seek out diversified exposure of higher-yielding bonds, notably the subordinated debts issued by financial institutions in Europe, thanks to the introduction of Basel III in 2009. Here you have to ensure the portfolio is actively managed across the sub-asset class, country exposure i.e., core vis-à-vis peripheral Europe, as well as the ability to reduce market exposure during a market sell-off, such as in March 2020.

Along with the positive macro backdrop, the Federal Reserve is expected to signal a gradual cessation of monetary stimulus in the coming months, initially with asset purchase tapering, followed by raising interest rates. The projection is for three rate hikes by the Fed in 2022, with another three to follow in 2023. Investors can also anticipate such a move by increasing their exposure to floating rate notes. In rising-rate environments, floating-rate funds can be expected to benefit from rising coupon payments and minimal interest rate sensitivity.

This is a sponsored article from Union Bancaire Privée’s asset management business.

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