As we noted a few days ago, the investment banking strategist community has been warning of a number of headwinds for fixed income markets in 2022. Rising yield curves have been central to these concerns, and indeed predicted central bank actions (or inactions) were probably responsible for much of the cautionary sentiment.
This concern about rates doesn’t come as a big surprise to us. As regular readers will know, we have been cautious on long dated government bonds since the start of the recovery phase, and pressures on the yield curve as well as on central banks to begin tightening have continued to build this year, resulting in investors now expecting both the Bank of England and Federal Reserve to hike rates in 2022, with the BoE widely expected to lift off next month.
This causes an issue for fixed income asset managers, and not just in government bonds, because of course as government bond yields move higher, any bond that trades on a spread to this reference falls in price; investment grade bonds are the most correlated, but higher yielding bonds are not immune either. The length of a portfolio’s interest rate duration is a good indication of how much exposure it has to movements in the yield curve, though as usual the devil is in the detail. Some government bond curves are probably better anchored than others; the European Central Bank is not expected to raise rates at all next year, for instance, so investors might be more tolerant of euro duration, but more fearful of dollar and sterling duration.
However, for those investors who do want to lower their interest rate duration risk without switching large numbers of bonds, an interest rate swap – a hedge that benefits from rising yields – is a relatively easy way to achieve this. Swaps have a number of benefits; they are highly liquid, easily traded and pricing is very transparent since numerous investment banks continuously quote rates. A swap thus allows investors to target the exact interest rate curve their exposure is coming from, and they can choose the point on the curve that in their opinion is most vulnerable to losses, i.e. giving them the best reward for their position. They can also size the position to take their interest rate duration to exactly where they want it to be. In the case of sterling swaps, the reference is now Sonia rather than Libor, which is controlled by the BoE and based on volume-weighted rates paid on eligible sterling deposit transactions. With a sterling interest rate swap, an investor can choose to pay the fixed rate and receive the overnight floating rate, which is simpler than the old method of choosing 1m, 3m or 6m Libor, and reflects the expectation of rate rises every day.
The sizing of a swap is very important, since in our view it should be sized as a hedge for the portfolio that is aimed at reducing the volatility attached to rising rates, rather than becoming the predominant overriding position. The position size will also determine the ‘running’ cost of the hedge; the difference between the floating rate you receive and the fixed rate you pay, multiplied by the size of the position relative to the portfolio, will tell you how much the portfolio’s running yield will be reduced by.
Notwithstanding the tightening we have seen this morning as investors digest the emergence of a new COVID ‘variant of concern’ identified in South Africa, we have a negative outlook on government bond yields in the medium term, and thus we think keeping bond positions short is a sensible strategy as we enter 2022. However, adding a swap on top can help portfolio managers keep their credit exposures while reducing their rates sensitivity even further as we enter the tightening phase of the cycle. With so many challenges facing investors in the coming six months or so, removing this potential headache could be a prudent move when sized correctly.