Below is the latest portfolio strategy from Matthew Macreadie. For clients interested, we would be investing a small amount in longer-dated investment grade, fixed rate bonds at regular intervals as it is inherently hard to time the market.
In the current high inflation environment and market/rate volatility, a diversified portfolio remains key no matter what path yields take over the year ahead. Thus, we still acknowledge a core floating rate book is necessary alongside this recommendation.
Whilst duration has underperformed over February, the RBA has counterintuitively improved the longer-term dynamics for bonds. We would be looking to lock-in some exposure to longer-dated investment-grade, fixed rate bonds which provide steady income and capital upside when or if rates move lower. Floating-rate bonds should also continue to do well in the short-term and provide a good running yield as 3m BBSW reaches its highs over the next 6 to 9 months.
As central banks reach the end of their current tightening cycles, the starting yields on many investment-grade, fixed-rate bonds look particularly attractive. These yields may not be around for long, creating an opportunity for investors to achieve higher returns before market conditions normalise. While the market attempts to forecast the RBA’s next move, we have seen yields on 10-year Australian government bonds move significantly wider by 40bps to 3.95% over February 2023. Contextualising this, 10-year Australian government bond yields have touched 4% but on average been around the 3-3.5% mark over the last year.
Even though inflation remains sticky in both Australia and the United States, the market is pricing that interest rate hikes will end at some point this year. In Australia, the RBA has raised interest rates nine times to the current cash rate of 3.35%, with the terminal cash rate sitting at 4.25% (as of 24/2/2023). The United States is more progressed in its journey, with the current cash rate of 4.75% versus the terminal cash rate at 5.25% (as of today). The difficulty is whether these interest rate hikes will control inflation and avoid slowing economic growth.
Based on the recent commentary, the RBA appears most concerned about inflation sticking around. This is a longer-term positive for bonds, as the RBA are lobbying to curtail inflation and growth simultaneously – which makes high quality, investment-grade bonds an even better buy. The same cannot be said for riskier assets, like equities and high-yield bonds. A good trade in our view, is to be long 10-year bonds and short 3-year bonds. The RBA’s rhetoric makes inversion of our yield curve (3-year, 10-year) more likely as growth expectations fall. Currently, the US yield curve (2-year, 10-year) is already inverted, and we would expect our curve to follow at some stage.
Nonetheless, trying to time the market is incredibly thwart with danger. We would suggest investors are better to lock-in some exposure to investment-grade, fixed-rate bonds. Primary markets have been offering considerable value, with new issuance reflecting higher starting yields. One such example is the ANZ 15-year non-call 10-year subordinated note offering a yield of 6.736% which is now trading at 6.54% (based on Bloomberg Mids). Furthermore, the Emirates Bank 10-year senior unsecured note offered a yield of 6.10% and is now trading at similar levels.
Despite short-term inflation spiking at 7.8% in Australia (based on the December Quarterly CPI figure), longer-term inflation is expected to eventually fall within the RBA’s target band of 2-3%. Forward pricing of inflation as measured by the 5-year, 5-year breakeven is pricing around 2.5%. In other words, this is the average inflation being priced by the market over 2028-2023. There are some positives to the deflation story, in both Australia and the United States. The unknown remains the possibility of wage price inflation.
On the other hand, floating-rate bonds have seen a sizeable uplift in the bank bill swap rate (or BBSW) since the RBA first started their interest rate hiking cycle. 3m BBSW is sitting at 3.5% (as of today) versus a level of around 0% one year ago. Floating-rate bonds will continue to offer good running yields as 3m BBSW will get reset higher over the proceeding months. Based on 3m BBSW forward rates, markets expect 3m BBSW to reach around 4.2% over the next 6 to 9 months and then taper off after that.
