Higher-for-longer interest rates are good news for investors seeking diversified returns from their multi-asset portfolios.
We used to hear a lot about ‘TINA’, meaning ‘There Is No Alternative’. This acronym, which became popular in the decade following the Global Financial Crisis of 2008 (GFC), referred to the view that the only assets offering the prospect of a decent investment return were equities (company shares).
Returns on bonds, by contrast, were depressed to extreme lows after interest rates were cut radically in response to the GFC. Further reductions to wafer-thin emergency rates during the Covid pandemic secured equities’ position as the only asset worth considering in the pursuit of returns that could beat inflation.
This held true until the economy reopened following the pandemic. Rampant inflation caused by pent-up savings from pandemic lockdowns and vast amounts of government spending spurred central banks to make some of the most rapid and sustained interest rate rises on record. In just a year and a half, the US Federal Reserve lifted interest rates 11 times, bringing its key interest rate to 5.25-5.5%.
This has been a painful process for bond holders and equity investors alike as bouts of volatility have rocked asset markets. But now, for the first time in years, higher yields on cash, bonds and yield-producing alternative investments provide viable options for delivering decent returns.
Furthermore, higher interest rates are likely to be with us for some time, until central bankers are convinced that inflation has been subdued.
Equities: seek profitable companies with high free cash flow generation
Higher interest rates have an immediate effect on how equites are valued. Investment managers assess how much should be paid today for cash flows that companies can expect to receive in future. The yields on 10-year maturity government bonds are a key part of these calculations; the higher the 10-year yield, the less value that equity investors place on companies’ future earnings.
Higher-for-longer rates and yields will have a significant impact. Compared to the era of low interest rates after the GFC, relatively less capital will be allocated to high-growth companies such as start-ups or rapidly-expanding software companies. As a result, we are likely to see lower equity valuations emerge in today’s expensive areas of the market.
Companies will also face a higher cost of capital, and this will be reflected in share prices. Businesses that got into the habit of borrowing money to sustain growth – by issuing bonds or by borrowing money in other ways – may need to reduce their reliance on debt over the next few years.
If companies do not make these changes, they will need to refinance debt when the agreed term of their existing debt ends. But in the new world of high interest rates, refinancing will be more expensive: companies will need to pay higher interest costs on their new debt.
For overly indebted companies these higher costs of doing business will result in lower earnings, which could in turn reduce the amount that their shares are worth. We therefore continue to emphasise quality companies that can point to proven track records of cash flow generation.
Opportunities grow for stock pickers
Despite our caution, the environment for stock pickers is improving. The post-2008 TINA environment was characterised by equities tending to move in synch, with low dispersion of returns between stocks. This meant there were fewer opportunities to select differentiated companies that could outperform the broader market.
The return to a focus on equity valuations and fundamentals brought by today’s higher-for-longer interest rates brings a welcome change. Investors are likely to be more discerning as to which companies offer genuine growth prospects and which do not. We can therefore expect to see more opportunities for investors to outperform equity benchmarks – provided they can demonstrate discipline and skill in their stock selection.
A good time for the better sort of bond
We have been positive on better-quality corporate bonds, known as investment-grade bonds, for some months now. These are bonds issued by companies that have robust businesses and reliable cash flows, and so are less likely to fail to make interest payments or repay their loans.
The expectation that interest rates will stay higher for longer has made these bonds even more appealing in terms of the balance between risk and return that they offer over the medium term. As a result, we have been adding to our holdings of investment-grade corporate bonds.
Many companies that issue investment-grade bonds were able to take advantage of extremely low interest rates during the Covid pandemic to borrow money for extended periods at low rates. These companies are still paying relatively low interest costs, which means that they are more likely to be able to pay the interest they owe and repay capital to bondholders when the time comes.
Meanwhile, buyers of bonds today are able to benefit from yields that are higher than at any time since the Global Financial Crisis of 2008. For bond buyers, the combination of higher yields and relatively low credit risk is highly attractive, creating a supportive market for good-quality bonds.
Treat higher-yield bonds with caution
We are much more cautious when it comes to lower-quality neighbourhoods of the corporate bond markets, such as high-yield bonds. The higher yields that these bonds offer reflect the substantially higher levels of risks that investors must accept in choosing to own them. At the moment, risks in high-yield bonds are elevated because companies that need to issue new bonds to replace expiring bonds will face much higher interest costs.
This is why we have seen the gap between the yields offered by better-quality bonds and riskier bonds widen in recent months. The bond markets have taken note of the risks they see ahead in lower-quality bonds and are demanding more compensation for holding them.
The short-term risks to floating-rate bonds are particularly acute. This is because the interest paid on floating-rate bonds and other forms of floating-rate debt fluctuates as interest rates rise and fall. With interest rates having risen so sharply since December 2021, many issuers of floating rate debt have been caught off guard. They simply did not expect interest rates to rise so quickly and by so much.
Government bonds: not without risks
While we are very much in favour of good-quality corporate bonds, we remain relatively cautious towards government bonds. Governments in the US and Europe continue to issue large amounts of debt. There is a possibility that spendthrift governments will be called to account by the bond markets, which are beginning to demand a higher return for lending money to them.
Meanwhile, central banks are reducing the stockpiles of government bonds that they built up after the GFC as they took steps to bolster the global economy and underpin financial markets. Central banks can no longer be relied upon as avid buyers of government bonds.
That said, we continue to hold selected government bonds that could prove to be desirable safe-haven assets in the event of further market upsets. We are keenly aware of mounting geopolitical tensions and lurking global economic risks. These include the possibility of military escalation in the Middle East and financial contagion caused by incidents such as the collapse of Silicon Valley Bank earlier this year.
Alternative investments: yields and inflation-hedging
With the worst of the interest rate rises behind us, we have reviewed our exposure to alternatives that have some similarities with equities and bonds. These include infrastructure - one of the worst-performing markets as interest rates rose. We believe it is time to revisit this sector, which offers good long-term potential as a result of urbanisation, modernisation and the transition to lower-carbon economies.
We also favour assets that are likely to perform well in response to the persistent inflation that underlies the outlook for higher-for-longer interest rates. Commodities are an obvious choice here, with oil and other hard commodities, such as gold, tending to do well during periods of inflation. Longer term, these holdings are likely to benefit from rising commodity prices caused by geopolitical tensions and climate change.
Overall, higher-for-longer interest rates are helpful for investors seeking diversified returns from a multi-asset portfolio. It’s time to bid farewell to TINA and welcome TARA – There Are Reasonable Alternatives.
Better yields on cash and bonds are finally providing a reasonable alternative to equities, and selected equities can also perform well in this environment. Furthermore, yield-producing alternative investments and inflation-linked investments such as index-linked bonds and commodities could benefit.
On the flip side, higher rates can increase economic risks, for example by making it more expensive for a company to borrow money to expand its businesses, or simply keep the business going. As this dynamic works its way through the global economy, investment markets will adjust to reflect the new normal – and this will make for more volatile markets. In this environment, investors should consider the benefits of hedging strategies that can help protect portfolios, or even enhance returns.
For multi-asset managers, greater volatility is not necessarily unwelcome because it increases opportunities to make tactical asset allocation choices between and within asset classes. Interest rate increases have been painful, but investors finally have a much fuller range of options at their disposal.
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