Investment Grade Versus High Yield

As we enter a new financial year, it is important to take notice of where yield and credit spread markets are currently sitting so that we can discern where value lies as investors.

The question on everyone’s lips is when do rates move and in what direction and inflation continues to be the key determinant for the RBA. As of today, the Australian economy continues to churn out data in support of the view of rates being higher for longer but let’s examine this more closely.

It is now the expectation of markets that a further rate rise is likely for the Australian cash rate and that any potential cuts have been pushed into next year. This has been supported by strong wage growth and tight employment data for the Australian market combined with stronger than expected inflation, particularly amongst durable goods which appear to have been the key contributor to the higher than expected inflation print informing the RBA’s stance.

Given the view that rates may rise by 25 basis points and then be followed by an easing cycle in mid next year, how should investors be optimising their portfolios to take advantage? As stated on several occasions, we are of the opinion that when yields sell off and we can add fixed coupon tier 2 and senior investment grade credit to portfolios above 6%, we should be adding with conviction.

When should we be adding this type of paper?

If we look at where 10-year Australian Government bond yields have traded since January, we have broadly ranged between lows of 3.955% and the highs of 4.52% and currently sit at 4.33%:

Source: Bloomberg

Under the efficient market hypothesis, it is assumed that all information available in the market is reflected in asset prices and with this in mind, the 10 year government bond has already priced in the expectation of a rate hike after the RBA minutes and hence why we are trading towards the top of the range. This occurred in mid-June on the chart above as the market digested the RBA minutes are yields sold off to reflect the growing possibility of the next move being higher. This begs the question, with us trading towards the top of the yearly range for the 10-year yield, is now the time to be adding duration to portfolios? To be clear, no one has a crystal ball and knows what will unfold over the coming months exactly, but the answer to that question in my opinion is yes, as long as we are garnering yields in excess of 6% or better which is achievable at current levels.

If we are able to add duration to the portfolio when yields are at or close to the top of the rate cycle, we can ride the easing cycle of rates downwards and amplify the return of these instruments in excess of their coupon payment rates through capital appreciation.

Additionally, while many investors like to hoard cash as rates begin to lower, data published by Vanguard and Bloomberg below clearly shows that Australian bonds typically outperform cash on a one- and three-year time period following the conclusion of hiking cycles in recent times.