Bonds : where to invest when descending from the interest rate peak
Volker Schmidt, Senior Portfolio Manager at Ethenea, gives his views on the current rates environment and explains what the impact is on the allocation of the Ethna DEFENSIV bond fund.
Rising interest rates are both a blessing and a curse. On the one hand, they reduce the value of existing investments. On the other, they increase the potential for positive performance in the future. “The portfolio of our Ethna-DEFENSIV bond fund suffered less than its peers during the period of rising yields,” says Volker Schmidt. “As a precautionary measure, we had reduced duration and shifted the portfolio towards euro-denominated bonds. At the same time, we have been buying newly issued bonds with significantly higher coupons, bringing our current yield to 4.5%, in order to offer an attractive alternative to fixed-term deposits.”
Many investors are betting on a rapid fall in interest rates and are buying government bonds with a long duration. “We are much more cautious and aware of many risks,” says Volker Schmidt, “especially the high levels of government debt on both sides of the Atlantic. Although we also expect the central banks to cut key interest rates, we do not share the markets' great optimism that the first cuts will be made soon. Wage growth remains high and threatens the central banks’ target of sustained inflation of around and below two per cent.”
A cautious stance is the basis of Ethenea’s investment decisions. Volker Schmidt : “Last year, we initially increased our duration and then recognised a tactical opportunity in the massive reduction in yields on long-dated bonds which we deemed an overshot. We therefore sold US and German government bonds on the derivatives market. However, the majority of our portfolio is in high quality euro-denominated corporate bonds with relatively short maturities, as we still see attractive yields in this segment. We are reluctant to take on duration risk due to the very high, abnormal volatility at the long end of the curve.”
Cautious with high yield corporate bonds
Ethenea’s baseline scenario does not include a recession. Volker Schmidt : “The strength of the US consumer is very pronounced, not least as a result of the continued strength of the US labour market. And the German economy is probably out of the woods. At the same time, the corporate issuers face significantly different financial conditions: the smaller companies are both disproportionately unprofitable and have more debt with variable interest rates and shorter maturities than their larger counterparts. Although this makes them riskier with higher yields, there are always opportunities in the high-yield segment. So, we are not ruling it out completely, but we are tending to be more cautious.”
Volker Schmidt is focussing on the attractive yields on corporate bonds : “We have therefore made only minor changes to the allocation between government and corporate bonds in recent times. Our sweet spot remains high-quality corporate bonds in euro.”
In addition to a possible scenario of interest rate cuts in the new year, there is also the possibility of high long-term interest rates or even rising interest rates. “We are not losing sight of this risk,” says Volker Schmidt. “For this reason, we currently have short positions on government bonds in our portfolio. This sets us massively apart from our peer group. We see long-term decline in yields, but with intermediate stops and possible rises at the long end of the yield curve. During this descent from the interest rate peak, we collect the coupon payments and constantly improve our strategy for better performance.”
The current inflation cycle is not a classic one, Fed Chairman Jerome Powell pointed out in his most recent press conference. “This means that inflation has not been triggered by excessive demand, but rather by limited supply as a consequence of pandemic restrictions,” says Volker Schmidt. “According to Powell, demand has been robust, but the lack of goods on the shelves had caused prices to rise. If this is the case, inflation will disappear as quickly as it has arisen. In this case, there would be no underestimation. However, if demand were to exceed supply, there would be a risk of a renewed rise in the price level, i.e. a return of inflation. Our opinion is a combination of the two: it is more a question of the persistence of inflation (at around 3%), not its rebound to higher levels. Central banks will therefore find it difficult to use monetary policy to achieve their goal of reducing inflation from three to two per cent.”
