Wednesday 24 July 2013 by Legacy

Fixed income market update (July 2013)

Please note that the figures mentioned in this article are no longer available.

Australian iTraxx

The Australian iTraxx Credit Default Swap (CDS) index tracks the performance of Australian corporates and is an indicator of credit risk for investment grade entities. The lower the spread, the lower the perception of credit risk. The charts below show performance over one month and one year.

Over the last month, the Australian iTraxx widened as QE jitters grew and global credit curves steepened. This then contracted back to levels similar to a month ago, however the iTraxx is now around 30bp wider than early May tights and back where it started the year.

Bond market in review

Domestically, the RBA left the cash rate unchanged at 2.75% in line with market expectations. Economic data was mixed with residential building approvals falling by 1.1% in May and retail trade growing by 0.1% in May. The May trade balance beat market expectations, with a trade surplus increase ($0.7bn) in May due to a 3.6% increase in exports.

Fitch has released its half yearly report "Australian Mortgage Delinquency by Postcode -31 March 2013". Delinquency rates across Australia have increased to 1.45% from 1.20% at the end of September 2012, but remains below the five year average of 1.53%. Increased arrears, particularly in low income/high unemployment regions, indicate RBA’s decision to reduce the cash rate did not positively impact mortgage performance in the six months to March 2013.

Offshore, concerns over the strength of the Portuguese government have reignited fears of a Eurozone collapse. Market focus has also returned to the Greek debt crisis as the latest review of Greece’s assistance program is underway. US economic news released shows the unemployment rate unchanged at 7.6%

S&P/ASX 200 Accumulation Index v UBS Composite Bond Index

The UBS Composite Bond Index is designed to measure the performance of the Australian bond market. The Bond Index consists of approximately 300 fixed interest securities issued by the Commonwealth Government, the State Government and semi government authorities as well as investment grade corporate issuers. This index provides a good representation of the movements in value and interest rates of this asset class.

Even though the fixed income market declined over the month, the Composite Bond index still managed to outperform the equities market with the S&P/ASX200 Accumulation index finishing June down -2.32%, a result which is 127bps lower than fixed income. Similarly, over the quarter to 30 June, equities fell -2.48% compared to the positive +0.40%. return of the Composite Bond index. The declining returns that the equities market has been experiencing over the last two months has resulted in fixed income continuing to pull ahead on a long-term annualised basis. The Composite Bond Index is 11bps clear of the S&P/ASX200 Accumulation index, as shown above.

Credit spreads

The data in the chart below is taken from Bloomberg Fair Market Curves. The credit spreads (over the applicable swap curve) are based on a five year maturity representing the composite credit spread of securities around that maturity for each ratings band.

Significant ratings changes over the month

  • Moody's affirmed the long term rating for Australia. The ratings agency said that "the diversity of the economy and the strength of the financial system lead to a very low level of event risk. However, the banks are dependent on foreign funding." Even so, Moody's noted that "the country's strong banking system insulated Australia from the contagion that affected other advanced economies" during the financial crisis starting in 2008
  • Moody's changed the outlook for the UK banking system to stable from negative, reflecting (1) the UK's increasingly stable economic outlook despite its low growth prospects (2) the consequent improvement in the outlook for asset quality despite downside risk to commercial real estate and peripheral euro area exposures (3) continuing improvements in capital ratios (4) improvements in funding and liquidity metrics will be maintained over the outlook period and (5) improving profitability and efficiency ratios due to lower impairments
  • Moody's has given ME Bank a strong endorsement in a ratings commentary. The ratings agency said the evolution of ME Bank's funding model in recent years, from one reliant on securitisation to one with a strong deposit base, would make it a more profitable business. Moody's expects that ME Bank's ability to generate capital from retained earnings will strengthen, such that it can eventually sustain its growth without periodic capital injections." Moody's also pointed to ME Bank's strong asset quality, saying it consistently reports arrears that are lower than system averages
  • S&P raised the outlook on Bank of Queensland on their view that future capitalisation could be stronger than current and historic levels. A rating uplift would benefit from further stabilisation of BoQ's asset quality position, which would support its profitability and capability of supporting permanently higher capital. The agency noted that the economic risk assessment for Australia may weaken but this alone would not prevent an upgrade of BoQ
  • S&P affirmed the ratings on Genworth Australia following a review of the Genworth Group's core life insurance companies. S&P anticipates that the partial IPO will be completed within the next year. If the partial IPO is not successfully executed, the agency stated they would review and likely lower the ratings on Genworth Australia by one notch, assuming all other rating factors remain unchanged
  • S&P downgraded Tabcorp. The rating action follows the recent reclassification of the group's hybrid in Mach 2013, the announcement that Tabcorp has agreed to pay $75m for a 20-year extension of its retail exclusivity in New South Wales wagering and S&P’s view that the company is not willing to maintain an underwritten dividend reinvestment plan beyond FY14
  • S&P lowered its long-term ratings on Barclays Bank PLC, Credit Suisse AG, and Deutsche Bank AG and affirmed the long-term ratings on UBS AG. The rating actions are due the increasing risks that Europe's large banking groups active in investment banking face as regulators and uncertain market conditions continue to make operating in the industry more difficult. In particular the agency considers that these banks' debtholders face heightened credit risk owing to the industry's tighter regulation, fragile global markets, stagnant European economies and rising litigation risk stemming from the financial crisis

Other comments from the facilitation desk

(Please note the following is sales commentary and is not to be considered research)

Higher long-term interest rates present opportunities for income investors – earn cash flow and return of 6%+

Last month, the US Federal Reserve announced they would start tapering off their enormous asset purchasing program (Quantitative Easing) toward the end of this year. The response across all risk assets was dramatic: in interest rate markets, we saw long-term interest rates spike significantly and we saw the prices of risk assets fall across the board. The below graph compares the Australian yield curve after the Fed’s announcement to where interest rates were being priced the same time 12 months earlier:

What this graph shows is that short term interest rates expectations remain low and flat, with interest rates spiking upward from 2015. This means that the returns on short term investments remain in the 3.0-4.5% area, while investors are rewarded by a much greater amount of return for holding investments which have a longer term to maturity.

In last week’s The Wire, Elizabeth Moran highlighted the opportunities now available for investors looking for income. Investors can now earn fixed, stable returns over 6% for corporate bonds in quality companies.

Prices are indicative and subject to the availability of offers. FIIG does not make a market in these securities.