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Portfolio Review: Bond Mix

So – what is a safe investment to help protect you from the ravages of inflation?

If one’s chief concern is inflation, then a higher allocation to floating rate notes would be advisable. However, there is a valid concern that the Australian bond market has priced in too much of the RBA rate hike – which means that fixed rate notes (and yields) will have to come down from here. Market expectations for the cash rate are over 3.5% by the end of 2022 − so 2.65% from the current cash rate of 0.85%, which is a long way.

Either way, nominal yields available via fixed or floating bonds to investors can make a meaningful contribution to combat inflation. A bit of both, fixed and floating, is probably the right option at this stage.

Turning to credit fundamentals, the threat of higher interest rates, slower economic growth, and rising inflation generally doesn’t bode well for credit quality − especially high-yield credit versus investment-grade credit. Many investors are focused on the cash rate and whether to buy fixed or floating, and have failed to understand what could happen to credit spreads and their performance.

Growth concerns are starting to manifest in falling commodity prices, with iron ore (on a USD basis) down 32% since 5 April highs (on an AUD basis this is roughly 27%). This directional evidence is worrying − alongside what we saw with the US yield curve inversion (10y2y) in April 2022.

All else equal, a weaker growth outlook and weaker terms of trade (from falling commodity prices) means the AUD could fall with increasing imported inflation. Weaker growth and higher inflation, resulting in stagflation, generally sees high-yield credit significantly underperform investment-grade credit.

Corporates are exposed to gapping yields and higher costs of debt. Investment grade, as opposed to high-yield companies, generally have more buffer to weather tougher times, which helps in relation to refinancing and interest service pressures.

Remember, the most recent sell-off in credit has been largely duration rather than credit spread driven. However, as the experience of March 2020 (COVID-19) showed, the bond performance of US high-yield just during that month was quite pronounced from a credit spread perspective: USD BB was down 9.2%, USD B was down 12.5%, and USD CCC – down 20.2%. This is a proxy for AUD high-yield credit spread performance, as there is no local high-yield index. Comparatively, AUD investment-grade was relatively protected during March 2020, with AUD AAA – flat, AUD AA down 0.5%, AUD A down 1.7%, and AUD BBB down 2.4%.

So, what should be done? There’s no doubt that increasing allocations to more defensive, low-beta credit (i.e., investment grade), as well as an appropriate mix of fixed and floating securities would be a strategically smart decision.

This doesn’t mean one ought to get rid of all their high-yield credit. It simply means that one ought to work on generating a high yield whilst having a bias towards better quality. It’s a smart tactic to selectively exit those high-yield names where there are more risks to the downside versus those high-yield names which have more of an opportunity to outperform in a tougher growth and inflation environment.

And though one might give up a little on the yield/income side by moving to investment-grade, investors are arguably getting very efficient returns for risk right now in investment-grade – e.g., many BBB bonds are offering 6-7% yield to maturity (YTM). However, there’s nothing burnt on the downside through a loss of capital − which almost always ends up being a realised loss in the high-yield space in a stressed scenario.

Examples of trade opportunities (all investment-grade and defensive, low-beta credits) we’d recommend include:

  • AIRNZ 6.5 05/25/29 (Baa2): YTM around 7%
  • PNHAU Float 05/12/27 (BBB-): YTM around 7%
  • ALDAU Float 12/09/2080 (Baa3): YTC around 7%
  • SYDAU 3.12 11/20/30 (Baa1/BBB+): Real yield above 3% (nominal yield of 8%, based on a 5% inflation assumption)
  • CBAAU 4.946 04/14/32 (Baa1/BBB+): YTC around 6%

To allow for these additions and to free up capacity:

  • CWNAU 0 04/23/2075 (Unrated): A name which has performed well and has acceptable credit risk. However, there are other floating rate opportunities offering 3m BBSW +400 where better risk/return exists.
  • EHLAU 6.25 07/10/26 (B+): A mining contractor more likely to encounter difficulties in a tougher growth and inflation environment. We’re already seeing the beginning of this, with falling iron ore prices (as noted above), which constitute a significant portion of the company’s earnings. One can achieve a YTM of 7% elsewhere with less risk.
  • MINAU 8 11/01/27 (Ba3): A miner with a significant portion of earnings coming from iron ore that are not hedged – aside from the earnings from the lithium business. It makes prudent sense to reduce exposure given challenges regarding growth and inflation. Again, one can achieve a YTM of 8% elsewhere with less risk.
  • SBSBNK Float 12/06/28 (BB+): A name which has performed well and has acceptable credit risk. However, there are other floating rate opportunities offering 3m BBSW +375 where better risk/return exists.

Note: YTM is based on Bloomberg pricing and not where IAM will execute. Purely for indicative purposes only.