Is it too late to join the hunt for yield?

June 2017

Is it too late to join the hunt for yield?

By Simson Sanaphay

For the first time in a decade investors face the prospect of a global trend of rising interest rates as economic growth resumes a more normalised upward path, meaning it’s time to review your portfolio.

1There is even a possibility United States rates may soon be higher than Australia’s, although Citi’s view is we will not reach that watershed, as Australian rates will start to rise in 2018 and reach 2.5% by calendar end 2020, compared to 2% in the US.

Gradual monetary tightening is expected over coming years

Across the board rate expectations shifting to upward trend Expectations inferred from market pricing on 9 May 2017. Source: Citi Research

Under a scenario of higher economic growth, rising wages and inflation and improving corporate earnings, equities should perform quite well as an asset class, and will likely steal the limelight that fixed income has enjoyed over the past decade. But that does not mean the chase for yield will fade, although strategies will certainly have to be adapted.

And there is no clear path back to synchronised global growth. Parts of South America, Africa and Central Europe face great challenges, and China is not as strong as it was just a few years back. Even in Australia, the nation that defied the Global Recession, we are now lagging key international peers in resuming a path to long term trend growth. A combination of a wind-down of the mining boom, a property boom that has stretched household debt and crimped consumer spending, and unemployment that is proving stubborn to bring lower, has placed the economy in a difficult transition period.

But in any environment there are opportunities to grow wealth, dependent on the strategy adopted.

Typically when interest rates are low or falling, the face value of a bond may increase on the secondary market, as they offer investors higher yield relative to newer issues. However, the opposite is true if interest rates start to rise, which is an important consideration with the current economic outlook.

Understanding bonds

Companies or governments issue bonds to raise capital, making them a form of debt. When you purchase a bond, the issuer pays you regular interest and will also repay the face value of the bond when it matures. Typically corporates pay a higher interest rate over the term of the bond, as there is a higher risk of default.

Shares are higher risk again. While shares may give you a proportion of company profit, via dividends, there is always the risk those dividends will be eroded by reduced profitability.

In terms of investment income, a blue chip stock like BHP may slash its dividends if profit performance is below expectations. But bondholders with BHP would still continue to receive their coupons at the same rate.

That’s why bonds can help you smooth out the income impact of equity market volatility on your investment portfolio.

Citi's current preference is to seek investment grade corporate bonds with medium (5 to 8 years) duration.

Investment liquidity

Unlike term deposits, you can also trade your bonds before maturity. If your bond face value rises due to changes in interest rates or issuer performance, there is a secondary market ready to buy.

Likewise, you may be able to purchase bonds at a discount (below the first issue price) on the secondary market and hold them to maturity, realising a capital gain in the process.
And certainly markets have already started reacting to the improved economic outlook, with investment flows switching from government bonds to corporate bonds, and a pivot towards shorter to medium term duration instruments.

So the strategy is really a question of allocating funds to the right class of bonds, and minimising interest rate risk through duration.

Citi’s current preference is to seek investment grade corporate bonds with a medium (5 to 8 years) duration.

When looking for opportunities, specific sectors to watch for include industrials, commodities and financials.
As reflation and growth reflect our overall investment themes, US credit with financials should benefit from steeper yields – and US corporates overall should benefit from expansionary policy and deregulation. The credit outlook in the industrial and commodities sectors have also improved.

Simson Sanaphay is Citi’s investment strategist.

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