Interest rate hikes: portfolios under review
Only one week has passed since the announcement of the biggest interest rate hike in the history of the European Central Bank (ECB) (75 basis points). According to MAPFRE Economics, with this measure, the ECB is “taking a moderately aggressive stance, signaling future efforts, and centering its discourse around the rise in prices.” In fact, markets are already setting their eyes on the body's next meetings, dismissing even steeper rises in the yield curve, though the matter will center around the maximum interest rate they should reach in order to, on one hand, control inflation, while simultaneously avoiding the more severe consequences of a possible recession.
The monetary tightening plan, which began just a few months ago as a result of the supply chain crisis and the war in Ukraine, has thus become another contributing factor to increased market uncertainty, making it more difficult for experts to find the best opportunities. Indeed, MAPFRE Gestión Patrimonial (MGP) experts are assessing what this measure may mean, both for variable income and fixed income.
First, the experts explain that an interest rate hike, in general terms, implies that there is “a liquidity squeeze for families and financial market participants,” thus affecting consumption and increasing capital costs. Naturally, this situation “is not good news for variable income,” although they qualify this by saying that “there are exceptions worth mentioning.”
On one hand, from a sectoral point of view (1), a measure of this magnitude would have less of an effect on “sectors that produce essential goods or services (health, basic consumer goods, and public services), as their consumption would be affected less than the consumption of products that are less essential to the end consumer,” they note.
They state that the banking and insurance sectors are an exception; their businesses “benefit from widening margins in their main business.” Furthermore, as far as non-life insurance companies are specifically concerned, the experts add that “their financial results improve when reinvesting premiums at a higher interest rate.”
In terms of company type (2), they highlight that companies “that are leaders in their market (such as Apple), or businesses with high barriers to entry and very high switching costs for end customers (for example, Microsoft)” would fare better.
As for company balance sheets, they recognize that companies “with a higher debt volume and those in early stages of growth” will suffer more “as it would be more difficult for them to access credit.” “However, overcapitalized companies with high volumes of liquidity could benefit due to greater cash-on-cash return,” they add.
Third, MGP experts suggest that, based on the investment period, (3), a difference must be made “between mature companies, with a greater short-term revenue volume, and companies who will take longer to see profits, the latter being more affected when these flows are discounted over a longer term.” Although, they explain, this will depend on “what level the curve stabilizes at once inflation has subsided, as profits should discount the real interest rate (after inflation). Therefore, we will have to wait and see what levels both prices and interest rates stabilize at.”
In the context of price drops in the bonds markets, wealth managers observe that “people were looking for very short-term bonds to protect themselves (despite how, due to their short-term nature, these may expose them to credit risks if they do not choose high quality bonds) as well as high coupons that maintain these bonds’ investment attractiveness.”
The recent interest rate hikes issued by the Fed and the ECB revealed a panorama that allows us to see an interesting medium to long term future for fixed-income markets as, according to them, “we are facing one of the most attractive moments for interest rates in a long time.”
But how can we take advantage of the interest rate hike? MAPFRE Gestión Patrimonial recognizes that “portfolio duration should be increased gradually and actively.” “Nevertheless, we still advise people to remain cautious in the short term. It’s important to highlight that there are contributing factors to this delicate market situation that have not disappeared, such as volatility and inflation, which are still there and may accentuate cumulative bond losses,” they add.
Because of the short-term noise, they emphasize the importance of “taking advantage of longer portfolio durations by diversifying across the entire spectrum of fixed-income assets and with a flexible duration positioning profile.” According to the financial advisory department, this could be achieved “through a flexible Fixed-Income fund that allows the manager to move around as they like based on their perception, and also by trying to look for added value in the credit rating to precisely adjust the quality/yield binomial (one of the main added values in asset management).”
They also add, in this context of fixed-income funds with high portfolio turnover: “This asset type accumulates very short-term maturities and profits from the reinvestment of those maturities at higher interest rates.”
In light of all this, which bonds are worth looking into? MAPFRE Gestión Patrimonial experts anticipate that “investment-grade bonds (those with a lower default risk that enjoy high ratings from credit rating agencies) are attractive investment options “as they leverage a high write-off mainly due to the duration effect.”
While it is true that the differentials of US and European corporate bonds have expanded due to fear of a recession (to give specifics, the US differentials went from under 100 basis points at the beginning of the year to 170 basis points at the end of July, and in Europe, they doubled to 200 basis points in the middle of August), at the current levels “default rates that are too high would be discounted,” they assess. Another alternative, in their judgment, would be securitizations with high credit ratings “as these leverage an attractive coupon and are mostly floating bonds.”