David French | 1/01/1900 12:00:00 AM

This article was originally published in The Morning Bulletin in May 2008.

Last week we discussed the investment clock and its usefulness to investors. Identifying the current state of the economic cycle can help investors position their portfolios to benefit from anticipated macro-economic changes. We showed that it is likely that we are at, or very near to, the top of the interest rate cycle. This implies falling interest rates in the medium term, possibly beginning in the first half of 2009. Based on this assessment, how should an investor structure their portfolio?

We believe investors should consider investing a greater proportion of their portfolio in fixed interest securities and interest rate-sensitive shares.

Interest rate-sensitive assets include banks, listed property trusts and infrastructure stocks and their securities are likely to outperform the broader market as the interest rate falls. However, investing in some of these sectors on the basis of interest rate changes must be made in the context of the state of the wider economy. Interest rates reductions are primarily made to offset slower economic growth; this slower growth will in turn affect earnings and profits, including those of banks and other listed companies.

Fixed interest securities, in particular some of the hybrid securities issued by some of Australia’s largest and most well-known companies, can be expected to increase in value as interest rates decline. Called hybrids because they posses the characteristics of both debt and equity, prices of these securities fell over the past 9 months as interest rates increased and the general share market declined. There are a number of hybrids, issued by stable, blue-chip companies, which offer yields that range from 10 to 20 percent if held to maturity.

Identifying hybrid securities which are suitable for investment requires close investigation of the conditions and structure of each hybrid. With differing coupon rates, maturity dates and redemption conditions, a detailed analysis should be made before investing in any hybrid security. More on that next week…

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