Yield direction and volatility
Yields drifted slightly lower over the week as economic data was light and market volatility was mostly attributed to the uncertainty in the Ukraine and soft data out of the US. There was continued concern that western nations will step up pressure on Russia as US President Barack Obama said there were consequences for being complacent over the annexation of Crimea. Soft US jobless claims and the US gross domestic product growing slower than expected for the fourth quarter further spooked markets. As such the 5 and 10 year benchmark swap rates slightly moved down over the week by 6-8 basis points (bps) to close the week at 3.71% and 4.40% respectively. Similarly the 5 and 10 year Commonwealth government yields lowered 7-10 bps to finish the week off at 3.42% and 4.07%.
On Monday, US Federal Reserve Chair Janet Yellen retreated somewhat from her hawkish stance the week before, where she had indicated QE would come to an end later this year and she saw higher interest rates in 2015. Yellen said on Monday that the Fed has not done enough to combat high unemployment and the world’s biggest economy will need Fed stimulus for “some time”. Speaking at a community development conference in Chicago, she said “The scars from the Great Recession remain, and reaching our goals will take time.”
US employment figures will be released on Friday night. Expectations are for 200,000 jobs to be added and for the unemployment rate to drop from 6.7% to 6.6%. This, as always, will be closely watched and any deviation from expectations will drive yields over the following week.
As universally expected, the Reserve Bank of Australia (RBA) kept monetary policy steady at 2.50% at its monthly meeting yesterday. The accompanying statement carried little in the way of indication for future direction of interest rates, implying the cash rate would remain at current levels until economic activity provides clearer signs of necessary action.
What do you do when value in fixed rate bonds is getting harder to find?
Six months ago, I wrote an article in The Wire expounding on how the steep yield curve was offering unique opportunities in medium dated fixed rate bonds. Since that time the yield curve has flattened by 20-30 bps and credit spreads have continued their steady march lower. As a result, those that took advantage of the opportunity would be pleased with the results.
Times change though, and now it is getting more difficult to find yield in fixed rate bonds. To illustrate this point, Figure 1 below shows available bonds yielding above 5.5% in investment grade fixed rate bonds six months ago, and Figure 2 shows the same choices today (for the sake of our clients, I am only including bonds available in parcels smaller than $500,000 through our DirectBonds service).
Figure 1
Figure 2
What was a selection of eleven choices has been reduced to a paltry four. Increasingly, investors seeking yield in fixed rate bonds are being encouraged to consider unrated corporate senior debt, which expands this universe considerably. Figure 3 contains the same choices today, but includes the universe of unrated corporate senior fixed rate bonds (red points).
Figure 3
Over the same timeframe, opportunities in floating rate notes at margins above 2.0% over bank bill swap rates (BBSW) have also diminished, but have been replaced with new issuance. Figure 4 and Figure 5 show the opportunities in floating rate notes six months ago and today, with the new issuance indicated by the red points in Figure 5.
Figure 4
Figure 5
The comparative resilience of opportunities in floating rate notes may be a convenient coincidence, as an improving domestic economy moderates the need for lower interest rates, and my own personal preference has shifted from an overweight fixed rate position to a more balanced portfolio of fixed, floating, and inflation linked products. While every portfolio should still contain at least a portion in fixed rate exposure, it is increasingly compelling to include unrated corporate senior debt issues in that allocation.
Other credit margins and trading activity
The Envestra and MPC Funding inflation linked bonds continued to trade tighter over the week, spurred by the credit upgrade to their credit wrapper, Assured Guaranty.
Taking centre stage again last week were the Floating Rate Note (FRN) bonds, as investors lapped up the quality offerings recently brought to market since the beginning of this year. Yet again the Insurance Australia Limited (IAL) March 2019 FRN line dominated the most traded bonds list, as it traded for its second week in the secondary market - with no sign of interest waning. Following closely in second place was the Bendigo and Adelaide January 2019 FRN line which remains in good supply and in hot pursuit with $4.5m traded over the week. Both lines were also actively traded the prior week, showing the demand for good FRN bonds that had been previously lacking. FIIG has ample access to both lines.
In the inflation linked space, the Envestra August 2025 inflation linked bond (ILB) and MPC December 2033 indexed annuity bond (IAB) continued their strong trading activity, spurred by the credit upgrade the week before to their credit wrapper, Assured Guaranty. The Sydney Airport November 2020 ILB line was the second most traded line as clients took advantage of improved supply (the bond had been harder to source a few weeks prior at these levels). Another line which made an appearance this week and can be harder to source was the Plenary Justice June 2030 IAB line, which was snapped up by pent up demand.
Below is a range of IAB and ILB lines that remain in good supply, priced as in indicative offer yield to maturity
- MPC Funding December 2033 ILA: 6.10%
- Sydney Airport November 2020 CIB: 6.30%
- Sydney Airport November 2030 CIB: 7.00%
Notes:
Offer levels are indicative as at 01 April 2014 and subject to change based on demand and market movements.
Yields for floating rate notes are estimated as the sum of the swap rate to maturity / call and the trading margin.
Yields for capital indexed bonds and index annuity bonds are estimated as the real yield plus a 2.50% inflation assumption.