This month has been somewhat historic for those of us that spend our lives following the fixed income market. We saw the first interest rate increase in Australia for circa 12 years. I actually wasn’t living in Australia back then - so it was my first interest rate increase since circa 2007 in the UK.
Ever since I joined FIIG in early 2014 we have seen yields grind gradually tighter. At times I thought that we might be following Japan, where rates have been held around zero for over 20 years. As interest rates fall more debt is taken on, and therefore the economy can become very sensitive to interest rate increases.
Perhaps unexpectedly, the path out of this low-rate funk has been a global pandemic which was met with huge monetary and fiscal stimulus. This was also quickly followed by a Russian initiated offensive into Ukraine. These events have managed to do what Central Banks have been struggling to achieve for over 10 years; they have created inflation.
The chart below shows the quarter-on-quarter (blue line) and year-on-year (red line) inflation readings going back to 1992. The Reserve Bank of Australia’s (RBA) mandate is to keep inflation within a 2% - 3% band, yet inflation has consistently undershot for much of the last decade.
That has changed in rather dramatic fashion with the last four quarterly inflation readings coming in above 3%, including the latest reading at 5.1%. The RBA’s statement accompanying its recent meeting said that “This rise in inflation largely reflects global factors. But domestic capacity constraints are increasingly playing a role and inflation pressures have broadened, with firms more prepared to pass through cost increases to consumer prices”.
The RBA expects inflation pressures to continue for much of this year before dropping back in 2023 and 2024. There is no shortage of commentators suggesting that the RBA has been late to react to the inflationary threat and the statement made clear that “inflation has picked up more quickly, and to a higher level, than was expected”.
This rise in inflation and the spectre of higher interest rates has pushed yields meaningfully higher across the bond market. This can be seen fairly dramatically in both the 10-year Government bond yield and Bank Bill Swap Rate (BBSW).
At the very beginning of 2021 the 10-year bond was yielding around 1%. This has now increased to 3.5%. That is a fairly staggering move, and it has had a punishing effect on the capital value of long dated, low coupon, fixed rate bonds.
I have been wary about long dated fixed rate bonds for many years. I was way too early on that call but what we have seen unfold over the last six months underlines the reasons for my view. The capital value of many of these bonds has come under considerable pressure.
Fortunately, without exception, they tend to be investment grade bonds issued by very solid companies. There are no credit concerns hanging over them, the yields to maturity are very attractive and I also think that there is the potential for some recovery in the capital values in the short term – to be explained below.
In comparison many short-dated bonds and floating rate notes have held up relatively well during this tumultuous period. Short-dated bonds have the benefit of the capital value being anchored to the maturity value ($100) to a certain extent.
Floating rate notes (FRNs) have languished for the last couple of years with BBSW effectively at zero. Over that time, we have seen a meaningful reallocation of capital towards FRNs, which makes sense at the bottom of the interest rate cycle, and that reallocation is about to pay dividends (actually, coupons in this case) as BBSW has also moved sharply higher.
It was only at the start of March that BBSW broke through 0.1% and two months later it has reached 1%. This means the next coupon resets for all FRNs are going to see a significant increase in coupon rates. A reward for those patient investors that have increased allocations to FRNs over the last year or two.
Contrary to what you might expect inflation linked bonds have actually been slightly soft over recent months. I think that this reflects the fact that many of these bonds actually performed very strongly when inflation was low, so they entered this period relatively fully valued. Given the inflation outlook I would remain comfortable maintaining inflation linked exposures and selectively adding into price weakness.
So where does this leave us today?
It is fair to say that the interest rate rise earlier this month didn’t exactly catch the market by surprise. That increase and many more are already fully priced in. The chart below outlines what the market has already priced in as far as interest rates are concerned.
As it stands the market expects to see approximately 10 interest rate increases before Christmas this year, which would take interest rates to about 2.5%. That seems to be extremely aggressive to me, especially when it is considered that the RBA only has seven meetings left this year.
This is a key reason why I think that we might see some recovery in the capital values of long dated fixed rate bonds i.e. if interest rates ‘only’ increase five or six times before Christmas then values would be expected to at least stabilise if not improve.
In fact, these aggressive expectations around interest rate increases are also making me rethink my core beliefs around on longer dated fixed rate bonds. At the moment we should be able to lock in healthy long term returns in investment grade names such as Tasmania State Government (AA+ rated) yielding about 4.5% indicatively, Wesfarmers (A-) at 5% or Pacific National (BBB-) at 6%+ and many more.
These look like extremely attractive returns to me however we are obviously relying to an extent on the ability of the RBA to do its job and get inflation under control.
Even for those not quite ready to invest longer term, the current market is unquestionably offering some of the best value that I have seen since joining FIIG almost a decade ago. Yes, there is some uncertainty in the air but that is part of what is creating the opportunity.
I may not be seen as the most impartial observer, but I think now is a fantastic time to contact your Relationship Manager to discuss the range of opportunities in the market.