Tuesday 26 July 2016 by FIIG Securities owl2 Opinion

Keeping an eye on volatility

As published in The Australian on 26 July 2016

Each day, investors keep an eye on the ASX200 and the S&P500 as well as other financial market indicators such as the gold and oil price and cross currency prices. Though it is hardly as well known, there is a similar indicator for bonds: it's known as the Australian iTraxx

Those of us working in the fixed income market, including large institutional investors, watch the iTraxx group of indices, which concentrate largely on corporate bonds. The Australian iTraxx is for bond investors what the ASX All Ordinaries Index is for equity investors: it shows movements and trends and enables bond investors to benchmark changes in their own bonds versus the broader market. It can also be used, together with other indices and information sources such as equity indices, the Volatility Index (VIX), interest rates and yield curves to gauge market sentiment and likely future direction.

How does the iTraxx help us?

First, it tells us that it is very hard to get a decent return in the top 25 most liquid bonds, which make up the investment grade index. The benchmark three month bank bill swap rate is about 190bps and if we add the spread of 110bps, returns on offer average 300bps or 3 percent per annum. The rate is similar to good term deposit rates but doesn’t have the upside potential nor liquidity available in these bonds.

Second, the differential in peak to trough is significant and dictates the momentum in the market to lower returns. It’s always good to invest over time and keep some funds on hand to invest in opportunities as they arise but the increasing possibility of an interest rate cut in August or September should now focus investor’s attention on the composition of their portfolios, and allocation to fixed rate assets that lock in returns.

In essence, the Aussie iTraxx is a “proxy” for credit spreads in the Australian market that is the return investors demand over the benchmark rate to invest in an investment grade corporate bond. When the market is nervous it demands a higher credit spread to invest and when it is relaxed, it’s willing to earn lower spreads and overall returns.

Importantly, it does not incorporate outright yields. That is, the movement in base interest rates such as the Government bond risk free rate, the RBA cash rate or the bank bill swap rate (BBSW). The Aussie iTraxx only looks at the credit spread component that is overlayed or added to the base interest rates or yield curve.

Aussie iTraxx is the best gauge of the direction of the market and if you are a bond investor or interested in the market it’s important to keep your eye on movements. It is difficult for non institutional investors to access the iTraxx but bond dealers and brokers should be able to provide you data if you ask for it.

To get a better understanding, take a look at the graph today: the blue line on the graph shows the change in spreads investors demanded to invest in the most liquid, investment grade bonds over the last eight years. You can see spreads pre GFC traded around 30 basis points (100 basis points =1 percent) but peaked as a consequence at around 430bps in March 2009.

This year the index has been quite volatile given its more recent stable past, reaching a peak mid February of 172bps, coinciding with the fall in oil prices, to a low last week of 110bps, that’s a big move. 

The Brexit vote caused significant global volatility, and while the iTraxx spiked from 123bps on 23 June to 138bps on 27 June, it was relatively steady compared to other financial market moves.

Generally, spreads continue to compress given the expectation that growth and interest rates will be lower for longer, but we are still some way off historical lows, leaving room for further compression. 

What is interesting is that the cash prices of the bonds in the index haven’t changed anywhere near the same extent as the index. Against expectations, prices are more stable. Fund managers are wary of selling bonds as they are afraid they won’t be able to buy the bonds back at a later date. 

One traditional way to increase returns has been to invest for longer but benchmark interest rates out to ten years are offering little incentive to do so.

Historic iTraxx data and weekly changes can be found on The WIRE and the Markit websiteExternal link - opens in a new window.