This investor says the "goldilocks" period is yet to come for bonds

The RBA's June rate hike didn't just surprise the economic consensus. It also shocked the life out of the bond market. 

The 3-year government bond yield increased by 32 basis points in a week and no less than seven research houses increased their terminal rate bets. Those higher for longer bets are all Capital Economics needed to make this next call:

"That aggressive monetary tightening will push the Australian economy into a mild recession in the second half of the year," Marcel Thieliant, head of Asia-Pacific at Capital Economics wrote to clients recently.

In fact, a recession caused by excessive interest rate hikes is the single biggest thing that keeps Pete Robinson of Challenger Investment Management up at night. 

"I'm relatively bearish in terms of the overall outlook," he said. 

"I think the cumulative impact of all those rate hikes are going to start to weigh on the household sector. I think there's simply some sectors that cannot sustain a cash rate in the five's."

However, just because the outlook is bearish, it does not mean that your portfolio has to go down with it. As part of Livewire's fifth annual Income Series, Robinson sits down for an interview to discuss the opportunities in fixed income and real estate. 

Edited Transcript

LW: What is your terminal rate forecast and how does it inform your investing strategy?

Robinson: It's a really tough call. I think I'm relatively bearish in terms of the overall outlook. I think the cumulative impact of all the rate hikes that we've had are going to start to weigh on the household sector, but it's going to take time, and this is the quandary that the RBA is facing. We've built up cumulatively on bank balance sheets. 

You can see around $250 billion worth of excess deposits, above trend deposits, sitting with the banks, so households have a lot of money and that's a big buffer as interest rates rise. So in an aggregate sense, it's going to take a while for that pressure to be felt. 

In the interim, what we've got is high levels of inflation and starting to see that inflation pass through to the wages side above the RBA's target. And so I think you're going to have to see them go again and potentially multiple times.

LW: Are you factoring in the possibility of excessive rate hikes into your portfolio construction?

Robinson: Absolutely. That's one big factor that we're thinking about at the moment. I think there are simply some sectors that cannot sustain a cash rate in the fives. There's just so much leverage that's been built up during the period of low interest rates that they can't cover their interest repayments when the cash rate goes to 5%. 

And that's not even factoring in, as default risk rises in the system, the fact that lenders will charge more for each dollar that they lend, so they're loading on extra credit spread on top of that higher interest rate. So think about the office sector where rents have barely moved. In the US, that's a sector under acute levels of focus. I think some of that focus is going to come here because if the cash rate hits 5%, I think we're going to see interest coverage ratios below 1x. 

So that means that the actual rents coming off the assets themselves aren't enough to pay the interest. And so the question is how do banks and non-bank lenders respond to that environment?

LW: How long do you expect this "goldilocks" period for fixed income to last?

Robinson: I don't actually think it's a Goldilocks period right now because inflation's so high. So inflation's eating into all of those returns. We have got CPI at 7%, and a cash rate at 4%, so actually, you're not having a very solid real return for your cash at the moment. So I think that the search for yield that we had during 2021 and 2022 is still on, but it's a search for inflation-adjusted yield. So we're still searching for that yield after inflation.

LW: What is the biggest opportunity in today's market and what is today's most over-hyped opportunity?

Robinson: I think the thing that I'm looking at really closely that I talked about before is the real estate sector. So we're currently quite underweight in real estate and have been for some time. It was very aggressively priced and in some respects, still remains quite aggressively priced. And really, I think that opportunity is going to emerge in the next six to 12 months as we start to see lenders having to recycle positions and they face those questions that I mentioned earlier of how do I deal with something where the interest coverage ratio is less than 1.5x where typically, the banks are setting their covenants, how do I address that issue? 

And what we're going to see is, I think, a transition of lending out of the banking system into non-bank lenders. So those non-bank lenders who have the capacity to undertake that lending are going to see some really attractive investment opportunities.

LW: Are investors really prepared for the impact of the fixed rate roll-off on the economy?

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