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Fixed interest and US banking

16 December 2016

How do you invest a bond portfolio in a rising interest rate environment?

Investing in traditional fixed income benchmarked portfolios will be challenging over the coming years. They have come under a fair amount of pressure which has been exacerbated due to the average maturity in these indices getting longer in recent years. This leaves investors in these products exposed to potentially a great deal of interest rate risk. Corporate borrowing has also extended as companies have taken advantage of these favourable lending rates to secure borrowing for prolonged periods. Any significant deviation from the ultra loose policy will impact investors seeking to capture gains from interest rate risk.

However, interest rates rise as a result of inflation, making inflation linked bonds more attractive. Shorter dated bonds, that may already price in rate rises, and floating rate bonds, where return rises with higher rates, can be attractive alternatives to broader conventional fixed income markets. There will be opportunities to still make money within the asset class as expectations tend to overshoot and correct. The best strategy is to stay nimble and invest in managers that have the flexibility to focus on capital preservation and seek to capture the upside of market dislocations.

What are your thoughts on the US banking/financial sectors for 2017, especially with the expected FED rate hikes?

US banks and financial equities had a strong performance after the election of Donald Trump. In a notable contrast to his election opponent, Hillary Clinton, he has been critical of excessive regulation in the financial sector and is widely expected to reform it. Much of this rhetoric was aimed at the Dodd-Frank Act which was passed in 2010. This law forced banks to raise capital and rein in riskier lending. A less cumbersome regulatory environment for financials could lead to a meaningful boost to profitability.

A combination of low base rates and fairly flat yield curves hampered bank performance prior to Trump’s surprise victory. The US Federal Reserve (“Fed”) has now increased interest rates twice by 0.25% since it lowered the base rates close to zero at the height of the financial crisis. Growth is expected to be stronger next year which could lead to further rate hikes from the Fed. The potential of less regulation and higher interest rates have given financial stocks a tailwind which, we believe, explains why they have rallied more than other sectors since the election result. It is worth noting that higher interest rates mean an increased interest burden going forward on household and company borrowing. This could eventually lead to more defaults; therefore lending standards have to remain sensible to capture these tailwinds over the medium term.

If Trump’s anti-regulation rhetoric is more than just rhetoric, and the Fed continues to gradually hike rates and lending standards remain sensible, then we may expect the financial sector to remain well supported.


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