Interest rate duration outlook more favourable

Oksana Patron

2 March 2023

The interest rate duration protection can provide a greater protection benefit against recession risk and the return outlook for interest rate duration is currently “considerably more favourable” than a year ago, according to Bentham Asset Management.

The tightening of financial conditions, which saw unprecedented cash hikes, increased the possibility of a hard economic landing and the government bond yields implied that cash rates will continue to rise.

But the markets were close to terminal rates in the US and other developed markets and with yield curves beginning to invert, historically viewed as an indicator of recession risk or that central banks had achieved their targets and inflation indicators (and rates) were receding, according to Bentham Asset Management managing director and chief investment officer, Richard Quin.

“We expect the impact to be greatest on economies such as Australia, the UK and New Zealand, where household mortgages have a higher proportion of floating rate interest. We believe central banks in these economies have less scope to maintain higher rates,” he said.

“We believe that interest rate duration exposure now has scope to provide a protection benefit against recession risk with a useful running yield. The downside risks for interest rate duration from here include quantitative tightening, or persistently high inflation. Either way the return outlook for duration is considerably more favourable than a year ago.”

At the same time, credit spreads in Europe were much higher when compared with similarly rated US credit sectors and the downside risk associated with the Russian invasion on Ukraine and associated energy risks continued to weigh on sentiment on European assets.

“Corporate earnings to date have been mostly supportive, and resultingly the level of defaults in the past year remain low. Corporate credit rating downgrade actions have started to outpace upgrades in the December quarter,” Quin said.

“We anticipate that the Q1 2023 reporting season will continue to provide more insight into the impact of the 2022 rate hikes on the corporate earnings outlook.”

Given this environment, the Bentham Global Income Fund, which saw a total return (after fees) of 2.02% in the December quarter, is now more defensively positioned compared with a year ago, a move highlighted by increased interest rate duration, portfolio liquidity, credit quality but decreased credit duration, the firm said.