Background
One unintended consequence (yet very welcomed by bond investors) of the current hiking cycle by the Reserve Bank of Australia is that interest rates are currently at levels not seen since the beginning of the last decade.
As it stands, the Australian government must pay close to 4% to borrow over a five-year period. That is about twice the average of the 2015-2020 period. As is often the case, higher base interest rates also translate into higher spreads (i.e. the risk
premium to account for the credit risk of the issuer), with current levels about 20 basis points above the average over the 2015-2020 period.
In this article, we look at some of our top bonds that were issued during FY23 so that you can be on the lookout for new opportunities in the new financial year.
AAA above 5% is possible
In mid-June, Bendigo & Adelaide issued AUD700m of covered bonds, with a 2028 maturity across two tranches: a fixed rate tranche paying a coupon of 5.10% and a floating rate tranche paying a coupon of 3M BBSW+1.15% (5.4524% for the current quarter).
Covered bonds are securities issued by banks that have an over-collateralised secured claim over a pool of mortgages which enables them to be rated AAA.
Having an allocation to a highly rated security is important because, even in highly dislocated markets, better quality credits will typically continue to be traded, hence provide an option for liquidity if required.
Institutional investors will generally use government securities for this purpose, but we like covered bonds because they provide a similarly very low risk and good secondary market liquidity in most circumstances, with a return uplift compared to government
securities.
Green can pay attractive returns
It is undeniable that we are experiencing a shift towards accelerated decarbonisation of the global economy. Going hand in hand with this is a surge in issuance of green bonds. At the end of June, global issuance of green bonds currently sits at about
63% of the levels experienced in 2022 and we are on track to potentially see total issuance for 2023 exceeding the previous highest year by up to AUD100bn.
In the past, we have seen many green bond issuances which were either from sovereign issuers or where the ‘green’ claim was debatable. With greater focus on ESG and more scrutiny on what constitutes a green bond, we are seeing an influx of
genuinely green issuers coming to market and this trend is likely to expand further over the coming years, which should make existing green bonds even more attractive.
Our pick amongst green bond issuers is the most recent Transpower seven-year fixed rate bond, issued at a coupon of 5.233%. New Zealand, already at the forefront of renewable electricity generation, has the aspiration of reaching 100% renewable electricity
by 2030. As is the case in many countries, the best locations for renewable generation are away from population centres and Transpower is key to bring green power to consumers.
Value in Tier 2 notes should continue
Another segment of the market which saw a lot of activity is the bank and insurance subordinated Tier 2 space. Year to date, we have seen over AUD8.6bn issued in the domestic market, equivalent to 85% of total issuance over 2022.
While instruments have historically been issued on the basis of a call five years post issuance, we initially saw Commonwealth Bank of Australia, then followed by ANZ and finally Westpac, stretching the structure to a non-call ten-year period which has
allowed investors to lock in attractive yields for longer.
While a number of banks globally have hit the headlines for all the wrong reasons, the Australian banking sector has proven resilient over the period, in large part because of the scrutiny local banks are under from the Australian banking regulator, APRA.
We also saw Tier 2 issuances from second-tier banks which have offered very attractive opportunities on a risk-adjusted basis. Our two top picks are the Westpac June 2033 call (by virtue of being the highest coupon on issue) and the Judo Tier 2 notes,
callable in June 2028.
The perfect return enhancer
Structured finance transactions seem to still suffer from the overly aggressive practices in the US pre-dating the Global Financial Crisis. But, if you look closely, many fund managers will have a material exposure to this asset class, with some holding
more than 40% of funds invested in residential mortgage backed or asset backed securities. This is because they provide very attractive returns and incomes on a risk-adjusted basis. And really, the Australian market is being punished for the (now
very dated) excesses in the US.
Moody’s Investors Services recently published its Impairment and Loss Rates analysis for this sector, covering the period between 1993 and 2022. Across Asia-Pacific, Moody’s rated 3,195 securities and only 17 of these experienced a loss, with
the bulk being linked to collateral debt obligations (CDO’s – which FIIG doesn’t trade).
Over the period, only one transaction suffered losses – this was a transaction issued in 2006 by Allco, with losses experienced in 2008 and 2009. In a separate study, Moody’s highlighted that, over the past five years, not a single transaction
in the Asia Pacific region saw any AAA tranches being downgraded or any tranches becoming a fallen angel (i.e. a rating transitioning from investment grade to high yield). You can also see our recent article on RMBS performance.
With spreads widening from their lows in 2020 and 2021, we see very good value across issuers and underlying assets. Our top pick is the recent inaugural issuance by Grow, backed by equipment leases.
Conclusion
While this article is focused on some of our preferred primary opportunities over the past 12 months, we expect similar opportunities to come to market over the next 12 months. With interest rates expected to remain elevated, now is the perfect time to
lock in attractive income and return, with investments that are also providing capital stability.