Navigating Rising Rates

Key takeaways

• With a number of central banks in the Developed Markets raising interest rates, Citi analysts believe that bond sectors which offer investors higher yield and strong fundamentals remain attractive.
• Within Asia, Citi sees opportunities in local currency India, Indonesia and China debt, given improving growth outlook and reform potential.
• Within US Investment Grades (IG), US banks are expected to benefit from an improving credit outlook and lower regulatory costs. Energy-related sectors remain attractively priced.

What does this mean for investors?

In this environment of gradually rising interest rates, Citi analysts believe that selected bond sectors which offer investors higher yield and strong fundamentals remain attractive. Given lingering political uncertainties globally (See "6. Politics — Risk Remain Elevated"), high quality bonds continue to remain an important part of investors’ portfolios, offering a degree of diversification.

Selective regional markets offer value

Higher relative yields, improved economic fundamentals and attractive valuations are likely to be supportive of Emerging Market Debt (EMD).

Within Latin America, Citi analysts continue to favor Argentina USD debt (sovereigns, quasi-sovereigns and corporates), Brazil (both local sovereigns and USD corporates), and Colombia (local and USD). Local Mexico sovereign debt is likely to remain volatile, though yields over 7.0% remain attractive. Still, possible trade conflicts with the US are meaningful and can negatively impact the peso.

Citi analysts view Venezuela’s debt restructuring as an isolated event, with little pass-through to the rest of the LatAm region. (See Chart).

While EMD is expected to outperform other bond sectors in 2018, the performance is unlikely to match 2017’s 9% gains as of 5 December 2017. 

Within Asia, local currency bond markets offer compelling opportunities. This is especially where growth outlooks are improving, reforms create longer-term optimism and lower inflation trends allow central banks to keep interest rates low. Citi analysts continue to favor local currency India, Indonesia and China debt.

Local currency onshore China bonds have become compelling, as 5-year local yields spiked to 4.0%, its highest level since 2014. The central bank has showed its preference for relatively tight liquidity to rein in leverage, while the economy remains strong. While foreign investors still have little exposure to Chinese bond markets, the launch of the “Bond Connect” – a platform to provide access to local China bond markets – can help open up China’s onshore bond market to the world.

Despite rich valuations, Citi analysts continue to remain overweight US Investment Grade (IG) corporates. US IG corporate yields are 3x higher than similar duration euro-denominated credit - 3.3% vs. 1.1% in 7-10 year maturities. The strong demand from non-US investors searching for higher yields is likely to remain supportive of US IG corporates.

Within US IG corporates, Citi analysts continue to favor US banks which are likely to benefit from an improving credit outlook and lower regulatory costs in the quarters ahead. Valuations of the energy-related sector, particularly the midstream/pipelines subsectors appear attractive.

In High Yield (HY) bonds, US HY offers one of the highest yields in the developed world at 5.4%. For comparison, European HY yields are closer to 2.0%. As US interest rates rise, higher yields can provide more buffer compared to other lower yielding fixed income options. Given improving fundamentals and lower default rates, Citi analysts remain modestly overweight US HY. Default rates are currently 3.1%, down from 5.1% in December 2016 and expected to fall further next year. That said, HY performance is expected to be more muted following 2017’s 7% gains as of 5 December 2017.

Citi analysts also favor financials within US high yields. While valuations in certain finance companies look relatively rich, these entities have restructured since the global financial crisis, are less concentrated to the auto sector and are well regulated. There is the potential for their credit ratings to be upgraded.