As central banks close in on their respective terminal rates, with the current tightening cycle widely expected to end this year, we look at the trading implications for the remainder of FY23 and how to best to position portfolios.
Background
Following central banks aggressively hiking rates last year, the year ahead should see terminal rates being reached. This will anchor yields which have progressively moved higher, creating a window of opportunity to take advantage of higher returns before market conditions change.
Although current inflation both here and in the US remains elevated (locally the December quarter CPI surprised to the upside, accelerating to 7.8%), and the Reserve Bank of Australia (RBA) has recently stated its priority is to “return inflation to target”, it’s largely expected hikes will end at some stage this year.
In fact, the cash rate futures market is pricing in rate cuts from September, with the view the RBA will begin cutting rates from May 2024. Likewise, the Fed Funds Futures market is pricing in rate cuts from September also.
Ahead of this, the market is pricing in another two 25 basis point (bp) rate raises from the RBA in March and April, with an additional ~15bp expected in June or July. The question remains if this will reign in inflation while avoiding an economic slowdown.
Against this backdrop, we believe there are key considerations and opportunities for fixed income portfolios. Current elevated yields present an opportunity to lock in higher returns on offer from strong investment grade fixed rate credits, while the coupons on floating rate notes will benefit from an uplift in the Bank Bill Swap Rate (BBSW) in the short term, providing better income. Selective high yield bonds in smaller allocations will help support higher cash flows, while non-AUD denominated bonds allows investors to better diversify portfolios.
Investment grade allocations
Fixed rate bonds
With yields higher, investment grade bonds are offering higher returns in the 5%-7% range, along with a lower risk profile. Also worth noting is that investment grade bonds have less credit risk compared to high yield bonds and typically perform better during times of economic slowdown.
While the RBA has flagged additional rate rises, with nine hikes already behind us, the bulk of the move in yields has likely already taken place. We are likely also closer to the terminal rate, as the table below shows a narrowing gap between the current and market-priced terminal rates (which factors in the additional three domestic rate increases for this year). Although typically fixed rate bonds are favoured in a rate cutting environment, we believe these elevated returns offer attractive buying value.
As the market tries to predict the RBA’s next move (with even the RBA seeming unsure), we have seen yields move 10-30 basis points (bp) in a matter of days (and at times retrace just as quickly), which we expect to continue until the outlook becomes clearer. As such, irrespective of where yields were two days ago or will be in two days’ time, it’s key to ask: do you like the yield on offer? Akin to picking peaks and troughs of economic cycles, investors all like the idea of a better yield, but trying to time it is another thing entirely.
Better to lock-in fixed rate opportunities that present good relative value; these will provide a steady income and potentially provide capital upside when or if rates move lower. The fear of missing out on the best yield possible, may result in missing out on a perfectly good yield currently available. As the chart below shows, the 10-year Australian government and US Treasury bond yields have had periods of breaking through the 4.00% level, but overall have remained elevated above 3.50%.
Primary markets have also offered stand out value, with new issuance reflecting these higher yields. One such example is the AAA rated AirServices Australia 2032 bond, which issued in November last year and priced at a fixed coupon of 6.00% and recently the ANZ Bank 15-year non-call 10-year subordinated note, rated BBB+, which priced at a fixed coupon of 6.736%. With the market view that rates rises will end later this year, primary markets present opportunistic buying at better returns.
While short-term inflation is spiking, longer term inflation is expected to eventually fall within the RBA’s target range with the 10-year break-even at 2.47% at time of writing, resulting in a relatively flat yield curve. The 1-year and 4-year swap rate is almost the same (also at time of writing), although noting a bond maturing in 1-year is likely to redeem in a lower rate environment. As such, we see value in fixed rate bonds with maturities 4 years and longer, where there is more spread between the different maturity dates providing additional return on offer. There is an additional ~25bps spread between the 4-year and 10-year swap rates.
Floating rate notes
Since the start of the hiking cycle, the Bank Bill Swap Rate (BBSW) has moved significantly higher, currently at 3.50% compared to 0.08% this time last year. The table below shows the 3M BBSW Forward Rates, with markets expecting 3M BBSW to reach 4.22% in 6 months and begin to taper in 9 months at 4.21%. It is set to remain above 3.50% for the sequential tenors. While the significant uplift since this time last year has translated into higher coupons on Floating rate notes (FRNs), it’s also worth noting the market pricing for rate cuts is reflected in the 3M BBSW rates.
Floating rate notes will continue to offer attractive running yields with 3M BBSW set to remain somewhat higher, although it’s noted a good allocation to fixed rate notes will help bolster a portfolio’s cash flows.
High yield exposures
There has been less of a focus on higher yielding bonds in the current environment, although high yield allocations support income in portfolios and even more so should rates begin to decline.
With the cost of funding now higher for issuers, and ongoing concerns around an economic slowdown, selecting high yield exposures with stronger balance sheets and in more defensive sectors is key. When selecting high yield exposures, it’s worth considering shorter dated exposures, where there is less outstanding debt due to mature prior.
We also believe periods of volatility and spread widening will create opportunities to add high yield bonds at improved entry points. Windows of spread widening should recover relatively quickly, as we saw across the last year, shown in the chart below of the Solactive FIIG Australian High Yield Index. The Index, made up of 31 unrated issues, shows short periods of weakness quickly followed by a trend higher. It’s worth noting also, the attractive big coupons paid by high yield bonds provide a buffer to any downward price activity.
Non-AUD
With the US Fed, among other global central banks hiking rates, generally yields on non-AUD denominated bonds have moved higher also, presenting attractive returns. While we continue to see volatility in currencies, rather than timing the entry, a strategy is to allocate a portion of the portfolio to non-AUD exposures and remain within that currency. Keeping in mind non-AUD exposures add further diversification to portfolios and allows investors to access opportunities/issuers that aren’t offered in the Australian bond market.
While we mention the AUD yield curve is relatively flat, the US yield curve is inverted- with the 2-year and 3-year yields higher than the rest of the curve out to the 2053 maturity as illustrated in the chart below. As such we see value in the short-dated end of the curve, in the 2-year to 4-year tenors, which provide additional return and for a shorter investment horizon.
Conclusion
While it remains to be seen if the RBA (and other central banks) keep to their expected rate hikes for this year, a diversified portfolio is key no matter what the path entails.
Higher returns on offer from fixed rate bonds provide attractive relative value while locking in an income stream if or when interest rates mover lower. Floating rate notes in the short to medium term will also provide a higher running yield with 3M BBSW reaching highs over the next 6-9months not seen since 2012. Selective high yield exposures in smaller allocations will supplement cash flows. We also believe there is value in holding non-AUD denominated bonds, which offer diversification to portfolios.
Constructing a well-diversified portfolio, with an exposure to fixed coupon bonds, floating rate notes, high yield and non-AUD denominated bonds will remain key for investors no matter what unfolds over the year ahead.