Ongoing interest rate rises around the world means returns from fixed interest assets will also continue to lift. This is good news for investors in the asset class, with a couple of caveats.
It’s also important to take a number of other variables into account when forming a view about the outlook for markets and fixed interest, such as softening economic conditions and heightened risks.
Osvaldo Acosta, Head of Fixed Interest Assets, answers the key questions currently surrounding the asset class.
What’s the outlook for fixed interest?
The rhetoric from the US Federal Reserve after its annual Jackson Hole meeting was quite clear. The central bank has every intention of putting the inflation genie back in the bottle by continuing to raise interest rates.
General market consensus is that overnight cash rates in the US are expected to head close to 5 per cent over the next 12 months, which may significantly dampen economic growth in the short-term.
This has prompted a softening in the value of risk assets such as equities, with share markets off the boil since the meeting. Concurrently, there has been a repricing of yields for fixed income assets, with risk free, two-year US Treasury bonds now generating yields of over 4.0 per cent.[1]
The lift in yields has now created opportunities not seen in the asset class since pre GFC. Therefore, for long term investors the characteristics that are expected from bonds have substantially improved. The asset class offers good income without having to increase the risk in portfolios.
How are diversified fixed income assets expected to perform?
Assuming a bond doesn't default and investors holds it to maturity, they should benefit from its income, as well as potential capital growth.
In a diversified portfolio made up of domestic and global fixed interest assets, the current market environment provide ample opportunities both in bonds and credit markets. This means that for those portfolios that have access to diversified sources of returns, they stand to gain the most in generating better risk adjusted returns going forward.
How are you positioning your portfolios to protect capital?
While we can't control the market, we can control how we invest, taking into account the risks to which portfolios are exposed. Our base case view is that markets will remain under pressure as central banks continue to lift rates to suppress prices, as financial conditions tighten it’s paramount that risks in portfolios are actively managed.
So, we have positioned our portfolios to be more risk balanced, by increased the liquidity and exposure to high-quality credit instruments. This helps protect capital during tougher financial conditions as the economy slows down, at the same time, supporting the portfolio to continue to generate attractive incomes.
Conversely, this environment will produce opportunities within the fixed interest asset class. As risks rise, credit spreads widen and bonds are likely to rally in a flight to safety, supporting positive returns. The added liquidity and defensive positioning of the portfolio means that we can be patient to take advantage of market dislocations as they rise.
What’s the outlook for interest rates from here?
In Australia, we expect cash rates to peak at around 4 per cent over the next of 12 months. This provides an opportunity to gain exposure to Australian government bonds, which are likely to generate a risk-free return in line with the cash rate.
In the US, consensus is that risk-free government bonds will also start to generate attractive income as cash rates peak close to 5 per cent.
This re-pricing of government bonds is encouraging investors to lift their exposure to this asset class.
How can you minimise capital erosion in a world of rising inflation?
Inflation is likely to remain elevated and so yields are likely to continue to rise. So, we remain relatively more exposed to short-duration bonds compared to the benchmark.
Overall, while markets will always move, our laser-focus on managing risk and protecting investor capital remains the same, helping to protect investor returns through market cycles.
Find out more
Speak to our Advisory Solutions team.
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[1] The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. Bonds issued by governments, such as those of Australia and the United States ,are described as ‘risk free’ because they are generally judged to be low risk. However, the value of bonds, even those issued by such governments, fluctuate in value. Nevertheless, the term ‘risk free’ is used in the investment industry to describe such assets.
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