Throughout 2022, we have observed increases across all the major components of fixed income return (bond yields, swap spreads and credit premia) and this has made for a challenging period to navigate for credit investors. However, as Michael Korber, Perpetual’s Managing Director, Credit & Fixed Income, explains, it is from these conditions that we can set foundations for future returns.
Tighter financial conditions bring with them the opportunity to access high quality issuers offering attractive yields on short-dated paper. Across our portfolios, we have been very defensively positioned for some time, which has allowed us to weather the recent volatility while building an arsenal of dry powder ready to deploy as these opportunities are presented.
Rising rates, tightening financial conditions and slowing growth are the most prominent risk drivers that are shaping the domestic credit market currently. From the perspective of a credit investor, a lower terminal rate and avoiding – or engineering a shallow – recession would be supportive for domestic corporate bonds. However, one of the aims of active management in this space is to build a portfolio of issuers that can meet their obligations through all conditions. We try to identify issuers with resilient cash flows as a result of a defensible market share and/or strong industry fundamentals.
One of the biggest impacts we have observed from central banks’ aggressive monetary and quantitative tightening is how tightening financial conditions have constrained liquidity. The US Federal Reserve’s balance sheet has more than doubled since early 2020 and they have embarked on the process of reversing the more than US$5T of purchases during the COVID pandemic. This is manifesting 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 during comparable periods in mid-2020 and during the GFC. Our portfolios have prepared for these risks in a number of ways. Elevated cash allocations, utilisation of synthetic positions including CDS, rotation to shorted dated paper and selective allocation to highly liquid government bonds are some of the tools our portfolio managers have deployed to manage liquidity risks.
The other key risk facing credit markets is slowing economic growth and the potential impact on corporate earnings. While economic growth has slowed considerably and recession risks continue to rise, the Australian economy can be resilient. While the economic backdrop looks similar to those faces by other developed economies – elevated inflation, tight labour markets and slowing growth – the RBA faces arguably a more favourable set of challenges with a potentially more powerful mechanism. Australian CPI and (as yet) wage growth has trailed the US and other developed markets, which makes the path back to target inflation somewhat less challenging. At the same time, the RBA has more direct impact on household spending as a result of very high household leverage and the prevalence of variable rate mortgages.
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There are differences in the macro-outlook for Australian fixed income but also structural and informational differences. Specifically in the corporate credit space, the domestic market is comparatively immature relative to the US. We continue to observe misunderstandings in the market regarding the risks and payoffs of corporate credit. You can see this in the different reaction of markets to recession risks and earnings downgrades. For some time prior to the most recent selloff, equity valuations have been very expensive relative to earnings.
Meanwhile, slowing economic and earnings growth concerns, alongside tighter financial conditions have seen domestic credit spreads expand to their highest levels in a decade. This discrepancy is especially puzzling when you consider then bondholders have priority over shareholders for every dollar of earnings.
Throughout these conditions, our focus remains on identifying issuers with robust cash flows, defensible market positions and healthy balance sheets. Quality issuers reveal their quality in trying times. The promising thing about credit markets at the moment is that these quality issuers will be offering greater compensation for their risk as a result of higher interest rates and credit yield premia. Our managers have built portfolios to withstand the elevated volatility and reduced liquidity of recent periods and we are ready to deploy capital where we expect to see high quality issuers offering competitive yields over short maturities.
While we are some ways away from a buyers’ market, there are already examples of promising deals that have printed wide of pre COVID levels. During October and early November, ANZ, Commonwealth Bank and Westpac all came to market with huge deals across senior unsecured and subordinated paper. The ANZ senior unsecured deal was the largest ever in the domestic credit market. These deals priced wider than recent issuance and offered a substantial premium relative to pre COVID major bank spreads. As banks begin to refinance their capital secured via the Term Funding Facility, we expect the pace of major bank issuance to accelerate. These deals are indicative of the trend we expect to continue with high quality issuers coming to market and offering more attractive spreads to take on their debt.
While there are substantial risks to negotiate in the current market context, we remain confident that our portfolios are well positioned to remain resilient. At the same time, as yields rise, we expect great opportunities to invest with quality issuers at attractive levels.
Originally published by MICHAEL KORBER, Managing Director, Credit & Fixed Income, Perpetual