VanEck: where interest rates are headed next and how to capitalise

Markets have been volatile and it caught investors by surprise when fixed income and equity markets suddenly became highly correlated in late 2022. Not ideal when fixed income is usually the defensive investment of choice in challenging times. Of course, there’s been a lot of water (and rate increases) under the bridge since then, so what do investors need to know about fixed income investments now?

Russel Chesler, Head of Investments and Capital Markets for VanEck Australia thinks bonds are looking attractive and the outlook for this asset class could be more positive than you think, even factoring his view that we haven’t seen the end of rate rises – or the end of higher rates in general.

“If you look at where we are at the moment, we’ve got unemployment figures going back towards historic lows, you’ve got house prices on the move. From our perspective, the RBA still needs to do quite a bit. 

I believe there’ll be at least one or possibly two rate rises. That’s positive for these floating rate bonds. They’re currently yielding about 5%. With a couple more rises, they’ll go up even further."

Chesler adds that when it comes to fixed rate bonds, "they're more dependent on a long-term rate. At this point in the cycle, we think long-term rates may be close to peaking because investors can see an end in terms of interest rate rises. From that perspective, it could be quite positive". 

In this edition of Expert Insights, Chesler discusses how the fixed income landscape has changed and what he sees on the horizon, the three big opportunities he likes in fixed income markets, and his tips for investors in this space on how to evaluate their investments.

Edited transcript:

How has the fixed income landscape changed over the last year?

The last year has been pretty volatile when it comes to fixed income.

If you look at what’s happened with rates, particularly long-term rates, we’ve seen the Australian 10-year government bond move from 4% in July last year to 2.97% two months later, and now it’s back at 4%.

If you look at fixed rate bonds, they’ve really moved around and we’ve seen a lot of investors have moved out of fixed rate bonds into floating rate type securities. They don’t want to take the interest rate risk where they see the value of their assets going up and down.

We’ve also seen credit spreads widen. They’re actually now higher than they were in March 2020. We believe they look quite attractive at the moment.

What is your outlook for fixed income for the year ahead?

If we look at the outlook, you need to look separately at fixed rate and floating rate bonds.

If we look at floating rate bond, the most important driver of the return is short-term interest rates. These bonds are generally linked to the three-month BBSW (bank bill swap rate) which follows the RBA cash rate quite closely.

If you look at where we are at the moment, we’ve got unemployment figures going back towards historic lows, you’ve got house prices on the move. From our perspective, the RBA still needs to do quite a bit. I believe there’ll be at least one or possibly two rate rises. That’s positive for these floating rate bonds. They’re currently yielding about 5%. With a couple more rises, they’ll go up even further.

When it comes to fixed rate bonds, they're more dependent on a long-term rate. At this point in the cycle, we think long-term rates may be close to peaking because investors can see an end in terms of interest rate rises. From that perspective, it could be quite positive.

Where do you think interest rates may end up here and abroad?

In terms of the RBA cash rate, my view is that there'll be at least one more increase in the next two months. There could even be two more. 

A lot of people say that then rates will come down in order to beat inflation. I think the rates are going to need to stay high for longer, and I don't expect those to come off until well into 2024.

If you look at the US Fed offshore, we've seen the inflation print come down, so the Fed's actually been on hold. I still think there's a reasonably good chance of still having another increase or two coming through there as well, as the unemployment rate remains incredibly low.

Where are the opportunities and risks in the fixed income market right now?

I see three opportunities at the moment.

Firstly, subordinated bonds.

These are tier-two bonds issued mainly by the big four banks. They sit a little bit further down in the capital structure, but they're offering quite attractive yield. At the moment, the yield to call on subordinated bonds is about 6%.

The next opportunity is in fixed rate bonds.

These bonds were shunned in 2022 when they actually fell in value. But what we're seeing now, is that long-term rates, the 10-year Australian government bond, is sitting at 4%. Certainly, our view is that we're getting to a point now where we are going to soon see a peak in the RBA rate, and we expect these long-term rates to either remain level or to come down. This represents a good entry point into fixed rate bonds.

The last opportunity is emerging market debt.

This is an asset class that's really been overlooked by most investors over the last 20 years. We've seen emerging markets be really fiscally prudent. They now have low deficits, low debt, and many are in a stronger position than developed markets. We believe that every investor should have some allocation to emerging market bonds.

What is your top tip for investors who want to access fixed income?

One of the key rules when I invest the key rule is to actually understand what I'm investing in and how it's going to perform in different markets.

When it comes to fixed income, I look at a number of different factors, and the first one's duration.

That really tells you how sensitive your investment or the value of your investment is to changes in interest rates. So, for example, floating rate notes generally have low duration because they keep readjusting as interest rates change. If you're investing in fixed rate bonds, you really do need to look at how long those bonds go out and what the duration is.

Secondly, you need to consider where are you investing?

Are you investing in investment grade bonds, which typically have a rating of triple B or above, or are you investing in high yield bonds? Liquidity is important. It's important to understand the underlying liquidity of what you're investing in. 

A good way to look at it is what happened in previous crises. We had one not that long ago in March 2020. Take a look at that and then really wrap it all together. You're getting paid a credit spread, is that credit spread fair for the risk which you're actually taking on?