With higher-for-longer policy rate backdrop and yield curve steepening, PM sheds light on opportunities
With inflation persisting well above central banks’ neutral rate target of 2%, policymakers have been signalling that interest rates are likely to stay higher for longer – though markets are continuing to hold out hope for a rate cut.
Against that backdrop, are there opportunities for investment advisors and portfolio managers to lean their clients’ fixed-income portfolios into?
That was one of many questions addressed by experts at CWB Wealth in a recent wide-ranging webinar discussion.
Citing Bloomberg data, Chief Investment Officer Scott Blair noted that Canadian bonds are up by about 2.3% for this year up to May 31. That marks a solid start to the year as it annualizes to about a 5% return, rebounding significantly from last year’s fixed-income carnage amid quickly rising rates.
Ric Palombi, senior portfolio manager of International Equities and Alternative Income, highlighted that historically, market expectations of Federal Reserve interest rates – represented by Fed Funds futures – have overwhelmingly tended to deviate from the actual Fed rate.
“When someone tries to tell you they know where interest rates are going to go, the probabilities of them being right [are] not very good,” Palombi said.
Before the Fed embarked on its aggressive policy-tightening campaign against inflation, Fed Fund futures indicated investors expected rates to be held at their accommodative near-zero Covid pandemic levels until 2026.
Since then, the market has been trying to play catch-up. By March 15 last year, they were anticipating the Fed would stop hiking at around 2.5%. Again, that projection was off; by the time the U.S. central bank declared a pause last week, it had pushed its policy rate up to 5%, and Fed Chair Powell is forecasting two more will be necessary this year.
“The bottom line is, when you're talking about interest rates, it's very difficult to predict where they go,” Palombi said. “But it doesn't mean you can't take advantage of the situation.”
Pointing to the Bank of Canada’s surprise 25-basis point hike in its recent June decision, he said the firm sees an opportunity in keeping interest rate exposures short.
As the market steepens the yield curve, he said yields on the short end – from two to five years – far exceed those for those in the 30-year range.
“For us, it makes sense to put our clients’ money there where the interest rate risk is lower, and you're getting higher yields anyway,” Palombi said.
Another approach Palombi’s team is employing, he said, is having an allocation to European alternative tier one bonds that are callable in the next two to three years. Those yield to calls, he said, currently range from 8% to as much as 11%, and are trading well below par.
“If they do get called, then you get a nice capital gain on top of that,” Palombi said. “If they don't, the yield resets are significantly higher than they are today, so the risk-reward looks very good on that as well.
“Trying to guess where interest rates are going to go [is a] low-probability event. Take advantage of what the market provides to you,” he said. “Taking advantage of the volatility, we think, is a better way to structure portfolios and get clients the best combination of higher income and higher capital gains down the road.”
