Plenty has happened in the month of May, with a change of government and the highest inflation number in decades to mention just two. Market interest rates have continued rising, both in the short-end and the long-end of the curve, although the short-end has risen faster with more and earlier hikes priced in:
This has resulted in a flatter curve, which is an indicator of a slowing economy. Unsurprising you might say when the cost of money has risen significantly, and I would agree. What is important though is to watch if the curve inverts – i.e. longer yields are lower than shorter yields. This has correctly predicted all recessions since WW2 and is a signal to take some risk off the table.
We aren’t there yet, and in fact the curve in Australia is still nicely steep with the spread between 2-year and 10-year government rates at 0.84% and a strong GDP number released yesterday, although they briefly got there in the US last month, so the antennae are tingling.
I continue to think that we won’t get as many rate rises as the market has priced in. The chart below shows 10 hikes by December which means a policy rate of over 2.6% in just 7 months. For this to happen I think the Reserve Bank of Australia (RBA) would have to raise by 2.25% in just seven meetings, which is an average of more than 0.30% per meeting, every meeting.
The market is also showing terminal rates of somewhere around 3.40% in mid to late 2023. I shudder when I think of the impact on housing of a mortgage rate 3.1% higher in a year than it is today. Housing and construction are so important to the wider economy that destroying a large part of this doesn’t solve anyone’s aims. A delicate balance for the RBA to come…
Value
So where is the value in this market?
Well, if the RBA are not going to get to where the market has them currently, then by definition over time the market rates have to fall. This is where bonds give you great asymmetry, because your downside is so low.
Take the recently issued AUD bond – the CBA 4.946% fixed 2027c bond. Currently available at a yield of 4.55%, this is a margin of 1.00% over the 5-year swap rate, making that 3.55%. Issued at a margin of +200 basis points (bps), this implies a tightening in the spread of 1.00% in a few weeks – which is way too much.
This tells me the bond market (as opposed to the short-term rates market) also doesn’t believe the hikes are coming, as there is no way CBA would have issued at +200 if they could have got away with +100 or so. The fixed rate bond has hugely outperformed the floating rate equivalent issued on the same day at the same margin, which is available still at a margin of +169bps.
If rates do in fact get to that level, then the capital price of the bond should remain stable as it is already priced in. Only if rates begin to be forecast to go higher or the rises come earlier will the bond lose value. If you can see more than 3.00% of hikes, then you are seeing something I don’t – please enlighten me.
The downside is that you might miss out on a few basis points of extra yield if rates do go higher, but it would take a huge effort for that to happen and also for the first time in a very long time for a rate hiking cycle to avoid a recession.
Conclusion
Given the huge rate rises priced into the market currently, we see value in short to medium term – say 3-5 year – fixed rate bonds. The advantage of fixed rate here is that they capture and lock in those market expectations even though they have not eventuated yet.
If they do as currently priced, then you will receive a return in line with the market. If not then you will receive the higher income as the coupon is fixed, plus there should be some price appreciation in the bond itself.
If however, more or earlier hikes do happen, then your worst case scenario is the yield you have locked in – in this case 4.55% for quality CBA paper, or indeed for the new very similar Macquarie bond priced on Tuesday at 5.85%.
This to me is a very asymmetric trade with the risk/reward balance in your favour, which are exactly the kind of trades that tend to generate outperformance, and when done in such a safe instrument as these bank Tier 2 subordinated notes, also give capital stability and income security – exactly what bond investors are typically looking for.