BY Paul Montaquila Fixed Income Director, Bank of the West

Jun 22nd 2022

Financial PerspectivesCFOs and Treasurers

Four Fixed Income Strategies for CFOs Facing a Rising Rate Environment

Jun 22nd 2022

After years of rock-bottom interest rates, the Fed’s aggressive battle with sky-high inflation presents challenges for corporate treasurers looking to lead in tumultuous times. But it also opens interesting opportunities for several low-risk fixed income strategies.

Here are four tactical moves we’ve been talking to clients about in recent weeks that have the potential to provide a bit more yield on cash and short-term, liquid investments.

  1. Extend on the Yield Curve:

    The rise in rates and steepening of the treasury yield curve means spread-related assets are much lower in price. That’s created an opportunity to take overnight liquidity and term out by moving out of money markets and extending out to a year or more. This could be a good time to transfer debt internally and capitalize short-term debt with long-term debt because rates inside a year have risen significantly since the start of 2022.

  2. Leverage Widening Credit Spreads:

    The Russian invasion of Ukraine has had untold global economic consequences in addition to creating a humanitarian crisis. The conflict has caused many credit spread products to deteriorate in the capital markets. Prices have fallen, even on assets without any direct connection to the war. This has created an opportunity to invest in debt tied to solid credit names. A bout of credit spread “widening” hasn’t happened in the current rising-rate cycle, but the environment is ripe for one.

  3. Put Cash into Money Markets:

    With the Fed’s discount rate lift-off out of the so-called “zero range,” holding cash isn’t as painful as it has been. Money market rates are inching upward and have more than doubled since March. That growth trajectory should steepen now that the Fed has made a .75 percentage point rate hike and indicated that more of those are on the table at future FOMC meetings.

“Money market rates are inching upward and have more than doubled since March.”

  1. Put in Place a Callable Roll:

    The current environment of heightened rate volatility creates an opportunity for treasurers to rollout a callable agency bond strategy. Callable agency bonds offer a higher coupon rate than non-callable bonds (the premium being due to the cancellation option). The holder then bears the downside risk of rates rising and the issuer declining to exercise their option, thereby leaving them with a below-market coupon for the life of the bond.

    One example: The Federal Home Loan Bank (FHLB) recently issued a bond with a two-year maturity, a call option of one-year, and a yield of 3.50 percent. At the same time in the market, two-year treasury bonds or even a non-callable option from FHLB had yields just over 3.00 percent.

    Given the long-term trend of interest rates coming down from decades ago, many treasurers assume the call will be exercised. That’s where the roll comes in. Expecting the call, they know they’ll have to replace the investment.

For some hypothetical portfolio allocations for companies with heavy cash, moderate cash, and low cash needs, see below.

Portfolio #1: 40% money market; 20% extend yield curve; 20% spread products; 20% callable rolls. This could be a smart move for companies with heavy cash needs, such as those in the real estate industry, where there can be hourly deal flow.

Portfolio #2: 25% money market; 25% extend yield curve; 25% spread products; 25% callable rolls. This could be good for companies with moderate cash needs, such as a public tech company that wants to be able to tap capital markets, sell stock, and have lots of cash.

Portfolio #3: 20% money market; 40% extend yield curve; 30% spread products; 10% callable rolls. This could be good for companies with low cash needs, such as public sector entities whose cash flows are more often predictable and result in large surpluses following an influx of tax money.

Want to learn more? Contact us.

CFOs and TreasurersRead Next