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Wednesday 31 July 2024 by Garreth Innes

Recalibration 2.0

In May 2023, I penned an article titled ‘Recalibration’, which dealt with the then-repricing of government bond yields and credit spreads. At that point in time, investors were guided towards a yield range of 5-6% on Australian Investment Grade corporate bonds. A lot has transpired in the last month, let alone since the time of our original Recalibration publication, so we thought it was high time to provide an update on these metrics and yield targets.

Interestingly, while the yield target is more or less unchanged, the underlying components have shifted meaningfully. Specifically, government bond yields have climbed a tad while credit spreads (the additional compensation required from moving from a credit risk-free government security to a corporate bond of the same maturity) have tightened aggressively (around 0.5% at the index level; see the lower half of the below chart).

And for those that are looking at the ‘tight’ spreads as a reason to lighten up on credit, it is instructive to look at the long-term spread chart to show that there were extended periods when credit spreads were significantly lower than current.

Clearly, the yield on corporate bonds is mostly driven by moves in government bonds with credit spreads a secondary consideration, outside of the odd crisis period. We are smack bang on the average spread level since 1996, so very nearly a 30-year track record. Pre-GFC, there was more than a decade of spreads hovering between 0.3 to 0.6%.

While Australian credit spreads have tightened, they still appear optically cheap compared with other global credit indices. US and European investment grade bond spreads have both tightened to levels below the current Aussie credit spread, despite the fact that both of these indices have significantly more interest rate risk (or duration) than our index – the US index currently has around 6.8 years of duration, while the Euro equivalent offers 4.7 years of duration. The Aussie credit index has just 3.7 years of duration*. If we were to adjust the credit spread on offer by the amount of interest rate risk present, Australian credit looks rather attractive in a relative sense. It gets even better once you take into account the one notch credit rating differential at the index level (i.e. Australia’s corporate index is slightly higher quality on average).

It would be unreasonable not to comment on the longstanding nature of this dynamic. Australian credit does tend to trade at a slightly lower ‘beta’ over the years – when spreads are widening, they tend to do so at a slower pace here in Australia and same when they are grinding tighter as they are now, although the current gap between US and Australian credit does look particularly attractive compared with the last 20 years.

Without looking into too much detail, investors would probably assume that the current compression in credit spreads is commensurate with the performance of stock indices. And when looking at the US IG credit spread, the forward P/E on the S&P500 or even the forward P/E on the ASX200, they would be correct. However, the bolded yellow line in the chart below once again shows the Australian corporate credit spreads are yet to return to September 2021 levels and are cheap on a relative basis versus other risk assets (for those readers prone to migraines, please look away now).

Armed with an update on yields and credit spreads, investors can now tune their portfolios to take advantage of the bond components they deem most attractive. We will see you soon for Recalibration 3.0!