How to rise above rising rates

April 19, 2018 | Last updated on April 19, 2018
3 min read

With interest rates on the rise, investors must focus on ideal portfolio positioning.

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In the U.S., the Federal Reserve has committed to gradual rate hikes, and, despite holding its benchmark rate yesterday, the Bank of Canada said higher interest rates will be warranted over time.

On the back of rate-hike news, the 10-year Treasury yield has increased almost half a percentage point since January, to four-year highs of about 2.9%. Some big bank economists are forecasting the yield to break 3% by year-end.

Robert Abad, product specialist at Western Asset Management in Pasadena, Calif., is keeping a close eye on rates to take advantage of opportunities. For example, U.S. yields got a boost in February when Fed chair Jerome Powell told Congress his personal outlook on the economy had strengthened.

Read: Is U.S. inflation on the rise?

Those comments “caused the market to price in expectations of four rate hikes for this year, which definitely was higher than consensus forecast coming into 2018,” says Abad, whose firm manages the Renaissance Multi-Sector Fixed Income Private Pool.

“We took advantage of the upward shift in Treasury yields to add to Treasury risk, mainly in the intermediate part of the curve,” he adds.

Further, the Fed’s commitment to measured rate hikes resulted in the three-month, U.S.-dollar LIBOR surpassing 2% last month for the first time since 2008. As a result, “we continue to add to our bank loan position,” says Abad.

“This allocation should benefit from a continued rise in LIBOR, and also in the event that inflation pressures do materialize.”

Read: Fixes for fixed income as rates rise

Farther afield with fixed income

Despite rising Treasury yields, Abad remains constructive on emerging markets (EM) debt. “Emerging market economies have stabilized for the most part, and are now better positioned to absorb shocks than at any other point over the past three to four years,” he says.

Rebounding oil prices add to his view.

“The stabilization we observed in commodity prices, such as crude oil, should also provide some support to commodity-producing countries such as Brazil and Russia,” he says.

Specifically, with valuations across U.S. dollar–denominated sovereign debt at multi-year lows, Abad sees “the best U.S.-dollar relative value opportunities” in EM corporate issuers.

“These would essentially be state-owned oil companies in Latin America, [which] benefit from continued improvement in sovereign fundamentals and have a more conservative approach to balance sheet management issuers than U.S. issuers at this point in the credit cycle,” says Abad, who also sees the best relative value in local-currency EM government bonds.

“This segment of the emerging market asset class offers strong return potential and diversification benefits across a number of countries with different interest rate and inflation cycles,” he says. Examples include Russia and Brazil.

“Russia right now is benefiting from a more positive growth outlook given stabilization in oil and gas prices,” says Abad. In January the IMF upgraded growth in Russia to 1.7% in 2018 from 1.6%, and forecast 1.5% in 2019. Those projections remain unchanged in the IMF’s latest report, released this week.

“In addition, as the currency has recovered, inflation has fallen and the central bank is cutting interest rates,” he says.

Likewise, Brazil exhibits an improving economy and declining inflation. This week, the IMF upgraded Brazil’s projected growth to 2.3% for 2018 and 2.5% for 2019 (increases of 0.4% for each above January 2018 projections). The IMF also said core inflation is “around historical lows” in Brazil, as well as Russia.

Accordingly, for Brazil, “Inflation-adjusted interest rates remain attractive relative to other global government bonds,” says Abad.

Also read:

S&P and TSX positioning as the cycle winds down

How to make life insurance products better in a rising-rate environment

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