The last year has been tough for FI investors as less accommodative monetary policy has led to both rising credit spreads and interest rates.
A lot of this has been due to central banks operating in a non-traditional approach (QE targeting rather than use of cash rate). Rather than the negative correlation investors are used to, a non-traditional approach to monetary policy has seen a positive correlation between interest rates and credit spreads.
However – this creates opportunities in investment-grade credit as well. Australian investment grade credit spreads and yields have materially increased. Investors can now lock-in some of the highest credit spreads and yields seen in the last decade. Many recent major bank subordinated instruments are offering 6% + (locked in for 5 years).
The higher cash rate is not yet impacting the state of economic conditions which is a positive for corporate credit. Economic conditions in a sense are holding up OK. While there is are recessionary risks that could grow if the RBA needs to go materially higher on the cash rate that the market is expecting to curb inflation.
Historically, the Australian default statistics are lower than the Global default statistics, in part due to it being a largely investment-grade market but also a concentration towards the major banks (all rated AA-). For example, a BBB rated bond has a probability of default over five years of 1.48%. This increases to 6.19% and 16.67% for a BB and B rated bond. If you want to dig deeper, a US BBB rated bond has a probability of default of 1.83% implying that an Australian BBB rated bond would have a probability of default over five years of significantly less than 1.48%. Again, this shows the safety net of the Australian corporate bond market.
Corporate credit and corporate Australia is still in good health. Structurally, liquidity in credit markets is significantly better than it was back in the GFC and banks are much better capitalised. Furthermore, Australian corporates have done a good job improving their financial position over the last year years.
In terms of curve –
•The backup in medium to long-term bond yields has provided investors with greater protection against a policy mistake by central banks and the potential risks of a recession.
•In our view, the three-to-five-year part of the curve offers the best bang for buck with around 80% of the yield and a quarter of the risk (or interest rate sensitivity).
- The risk is if the RBA needs to go materially higher on the cash rate than the market is expecting to curb inflation. Then medium to long-term bond yields could move further upward. Our view is we are not there yet.
- Fixed/Floating – The challenge. Anyone who thinks the market is pricing rates too high should go fixed and grab the rate on offer now. Anyone who thinks the market is correct or rates will go higher should go floating. I think it makes sense to have 50/50 Fixed/Floating.
- The chart below shows the 30-day cash rate futures curve until February 2024. The market is expecting short-term rates to reach 3.58% by May 2023. But then, the market expects cash rate cuts going into late 2023/early 2024.
About Matthew Macreadie
Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific credit issuers with the aim of aiding investors to make better risk-return decisions. He is also part of a team of four within the Debt Capital Markets (DCM) team, which provides corporates, financials, property, and infrastructure companies with flexible funding solutions.
Prior to joining Income Asset Management, Matthew spent eight years working as a Senior Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of investment-grade/high-yield, financial and non-financial sectors. Reporting directly to the Head of Australian Fixed Income, he oversaw a team of four and was the team’s ESG specialist.
Matthew has executed 1, 3, and 5-year credit-strategies that have been consistently above benchmark.
Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group and then spent six years at Colonial First State Global Asset Management as a Fixed Income Credit Analyst.
Matthew holds a Masters of Applied Finance degree from Macquarie University and a Bachelor of Commerce degree from UNSW.