The US 10-year bond rate rose above 3% this week. Whilst only a psychological marker, it is watched by many market participants and clearly shows a meaningful change in the global interest rate environment over the last year.
The markets weren’t that surprised by the rise above 3% as it was not unexpected. The US market was down a fairly modest 1.3% on (it's) Tuesday, the day it happened.
Source: IRESS, First Samuel
A big deal?
The US 10-year bond rate has clearly risen but is not at excessive levels (we got quite use to very low rates as a result of the US Federal Reserve GFC-driven stimulus). But it is a substantial change when compared to rates as low as ~1.5% in mid 2016. And it is significant as it is a pointer to increasing interest rates generally – it is a quasi-benchmark for interest rates globally, and perhaps the most significant one.
We can’t predict rates. Maybe they will settle at this level. Maybe they will continue to rise. We suspect they will continue to rise somewhat, noting the US Federal Reserve is likely going to need to raise rates to get back to a more neutral setting, and to dampen US Government tax / spending stimulus. But we don’t invest on suspicions.
Are you positioned for increasing interest rates?
A key consideration in investing is companies' gearing. Is it low and sustainable? Low debt, along with the ability to service debt in difficult times, and obtain refinancing as debt facilities come to expire, is key. Additionally, we seek to avoid long duration assets (for example, long-dated bonds, or property) in the current environment.
We are particularly cautious regarding the property sector. It is sensitive to interest rate movements (compounded by high payout ratios and comparative based valuations), and assets (properties) tend not to be liquid in a stressed market.
We anticipate that two of your investments, QBE Insurance and the Crown Hybrid, will actually benefit from a higher interest rate environment. QBE because of higher investment returns (from typically short duration interest rate sensitive assets, which generate increased profits for shareholders), and the Crown Hybrid because it is floating rate (i.e. its distributions are linked to an increasing reference interest rate).
Income Securities' portfolios
Some clients have an Income Securities' portfolio. Of note in the current environment is that we are careful about credit quality (debt levels and the like), and the majority of investments are floating rate (i.e. distributions will increase as their interest rate benchmark, usually BBSW, increases).
Who will get hurt?
Higher bond rates are likely to impact everything from borrowing rates, to commercial property valuations, to the sustainability of sovereign debt for a number of countries. And higher rates may have an even greater impact now, as debt levels around the world (including in Australia) have actually been increasing since the GFC.
Specifically, those who should be concerned are companies and individuals that have too much debt and not much income. And long duration assets.
Key interest rate measures have been marching up over the last year, with the 10-year US bond rate increasing above 3% this week. Your Investment Team is mindful of the impact that increasing rates could have on your portfolio.