Seizing Opportunities in Interest Rate Securities

Recent surges in bond yields make interest rate securities, particularly investment grade credit and longer-term fixed-rate government debt, attractive compared to equities. We explore options in investment grade credit, fixed-rate government debt, term deposits, and private credit, and look at the areas that require caution.

The jump in official and long-term interest rates has improved prospects for interest rate securities. Recent attention has been on government bond yields that have surged higher.

This has changed the landscape for this asset class and investors should be looking to increase their exposure. In many instances, interest rates securities now offer a better combination of risk and return than equities. In the US market, yields on investment grade credit now exceed the earnings yield on equities for the first time in 15 years.

The sharp jump in bond yields has a range of causes. Resilient economies and rising oil prices suggest that inflation may not be completely extinguished. There are also concerns that some major holders of US government debt will now be ongoing sellers (the Bank of Japan, Chinese reserves and the Federal Reserve through quantitative tightening), and future US bond issuance will be substantial to finance ballooning budget deficits.

Higher rates have flowed through to parts of the market in different ways. Floating-rate securities with shorter maturities have seen the biggest jumps in yields. This is behind our preference for investment grade credit. With the resetting of interest rates these are now offering returns of 7-9% – around double the rate of a couple of years ago.

The recent jump in longer-term fixed-rate government debt now also makes this asset class attractive and we have begun to build positions here.

Term deposit rates are starting to rise and there are now some offers around 5%. Investors should be careful about locking away money for too long, however, because ongoing volatility in markets could create opportunities for those with cash on hand. Returns for hybrids have also risen in line with the increase in short term interest rates such that current yields-tomaturity are around 6%. Further increases in rates could push them up further.

Investors should also consider some exposure to private credit. Some corporate borrowers are struggling to access funds because banks are less willing to lend and listed debt markets remain effectively shut to new issuance. They are increasingly turning to private credit providers who are able to charge higher rates with more favourable terms. This is an opportunity for investors, but investors should also be wary of the potential for rising defaults and ensure they invest with experienced managers.