Throughout 2022, we have seen increases in all major components of fixed income yield (bond yields, swap spreads and credit premia), which has made the period difficult for credit investors to navigate. . However, as Michael Korber, managing director, credit and fixed income, of Perpetual explains, it is from these conditions that we can establish the basis for future returns.
Tighter financial conditions offer the possibility of access to high quality issuers offering attractive yields on short-term securities. Across our portfolios, we have been very defensively positioned for some time, which has allowed us to weather recent volatility while building a dry powder arsenal ready to deploy when those opportunities arise.
Rising rates, tighter financial conditions and slowing growth are the main risk factors currently shaping the domestic credit market. From a credit investor’s perspective, a lower terminal rate and avoiding – or staging a shallow recession – would be good for domestic corporate bonds. However, one of the objectives of active management in this space is to build a portfolio of issuers capable of meeting their obligations in all circumstances. We try to identify issuers with resilient cash flows due to defensible market share and/or strong industry fundamentals.
One of the most significant impacts we have seen from aggressive central bank monetary and quantitative tightening is how tighter financial conditions have constrained liquidity. The US Federal Reserve’s balance sheet has more than doubled since the start of 2020 and it has embarked on the process of reversing the more than US$5,000,000 in purchases during the COVID pandemic. This manifests in reduced secondary market liquidity, where bid sizes are small and bid/ask spreads are wide. The domestic credit market can be sensitive to liquidity shocks, as observed in periods comparable to mid-2020 and during the GFC. Our portfolios have prepared for these risks in several ways. High cash allocations, use of synthetic positions including CDS, rotation into short-term securities and selective allocation to highly liquid government bonds are some of the tools our portfolio managers have deployed to manage liquidity risk.
The other key risk facing credit markets is slowing economic growth and its potential impact on corporate earnings. As economic growth has slowed significantly and recession risks continue to rise, the Australian economy may be resilient. While the economic backdrop resembles that of other developed economies – high inflation, tight labor markets and slowing growth – the RBA arguably faces a more favorable set of challenges with a potentially stronger mechanism. Australian CPI and wage growth (again) tracked the US and other developed markets, making getting back to target inflation a little less difficult. At the same time, the RBA has a more direct impact on household spending due to very high household debt and the prevalence of variable rate mortgages.
There are differences in the macro outlook for Australian fixed income, but also structural and informational differences. More specifically in the area of business credit, the domestic market is relatively immature compared to the United States. We continue to see misunderstandings in the market regarding the risks and rewards of corporate credit. You can see this in the different market reaction to recession risks and earnings downgrades. For some time before the last sell-off, stock valuations were very high relative to earnings.
At the same time, concerns about slowing economic growth and earnings, as well as tightening financial conditions, have seen domestic credit spreads rise to their highest levels in a decade. This discrepancy is especially puzzling when you consider that bondholders have priority over shareholders for every dollar of income.
Under these conditions, we remain focused on identifying issuers with strong cash flows, defensible market positions and healthy balance sheets. Quality senders reveal their quality in difficult times. What’s promising in credit markets right now is that these quality issuers will offer greater compensation for their risk due to rising interest rates and credit yield premiums. Our managers have constructed portfolios to withstand the high volatility and reduced liquidity of recent times and we are prepared to deploy capital where we expect to see high quality issuers offering competitive returns at short maturities.
Although we are some distance from a buyer’s market, there are already examples of promising deals that have far exceeded pre-COVID levels. In October and early November, ANZ, Commonwealth Bank and Westpac all came to market with huge trades in senior unsecured and subordinated securities. ANZ’s senior unsecured deal was the largest ever in the domestic credit market. These trades were priced higher than recent issues and offered a substantial premium over pre-COVID major bank spreads. As banks begin to refinance their capital secured by the Term Funding Facility, we expect the pace of major bank issuance to pick up. These transactions are indicative of the trend we expect to continue with high quality issuers entering the market and offering more attractive spreads to assume their debt.
Although there are substantial risks to trading in the current market environment, we remain confident that our portfolios are well positioned to remain resilient. At the same time, as yields rise, we expect great investment opportunities with quality issuers at attractive levels.
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