Throughout 2022, we have seen increases in all major fixed income components (bond yields, swap spreads and credit premia) and this has made it difficult for credit investors to navigate. However, as Michael Korber, Managing Director, Credit & Fixed Income at Perpetual explains, it is from these conditions that we can lay the foundations for future returns.
Tighter financial conditions bring with them the opportunity to access high-quality issuers that offer attractive yields on short-dated securities. Across our portfolios, we have been very defensively positioned for some time, which has allowed us to weather the recent volatility while building an arsenal of dry powder ready to be deployed when these opportunities present themselves.
Rising rates, tightening financial conditions and slowing growth are the most important risk factors currently shaping the domestic credit market. From a credit investor’s perspective, a lower terminal rate and avoiding – or engineering a shallow recession – would be supportive for domestic corporate bonds. However, one of the goals of active management in this space is to build a portfolio of issuers that can meet their obligations under all conditions. We seek to identify issuers with resilient cash flows as a result of defensible market share and/or strong industry fundamentals.
One of the biggest impacts we have observed from aggressive monetary and quantitative central bank tightening is the way in which tightening financial conditions have constrained liquidity. The US Federal Reserve’s balance sheet has more than doubled since the start of 2020 and has begun the process of undoing more than $5 billion in purchases during the COVID pandemic. This manifests itself in the reduced liquidity of the secondary market, where bid sizes are small and bid/offer spreads are wide. The domestic credit market can be sensitive to liquidity shocks, as observed during comparable periods in mid-2020 and during the GFC. Our portfolios have prepared for these risks in various ways. High liquidity allocations, use of synthetic positions including CDS, rotation towards short dated securities and selective allocation to highly liquid government bonds are some of the tools our portfolio managers have implemented to manage liquidity risks.
The other key risk facing credit markets is the slowdown in economic growth and the potential impact on corporate earnings. While economic growth has slowed significantly and recession risks continue to rise, Australia’s economy can be resilient. While the economic backdrop is similar to that of other developed economies – high inflation, tight labor markets and slowing growth – the RBA undoubtedly faces a more benign set of challenges with a potentially more powerful mechanism. Australian CPI and (so far) wage growth has tracked the US and other developed markets, which makes the path back to inflation targeting a little less challenging. At the same time, the RBA has a more direct impact on household spending due to very high household leverage and the prevalence of adjustable rate mortgages.
There are differences in the macroeconomic outlook for Australian fixed income, but also structural and informational differences. Particularly in the corporate credit sector, the domestic market is relatively immature compared to the United States. We continue to see misunderstandings in the market about the risks and rewards of corporate credit. You can see it in the different reaction of markets to recession risks and earnings downgrades. For some time prior to the latest selloff, equity valuations were very expensive relative to earnings.
Meanwhile, easing fears about economic growth and earnings, coupled with tighter financial conditions, caused domestic credit spreads to expand to their highest levels in a decade. This discrepancy is especially puzzling when you consider that bondholders have priority over shareholders for every dollar of gain.
In these conditions, our focus remains on identifying issuers with robust cash flows, defensible market positions and healthy balance sheets. Quality issuers reveal their quality in difficult times. The promising aspect of the credit markets at the moment is that these quality issuers will offer greater compensation for their risk due to higher interest rates and credit yield premiums. Our managers have built portfolios to withstand the high volatility and low liquidity of recent periods and we are prepared to deploy capital where we expect to see high quality issuers offering competitive yields over short maturities.
While we are far from the buyers market, there are already examples of promising deals that have surpassed pre-COVID levels. During October and early November, ANZ, Commonwealth Bank and Westpac all entered the market with huge deals on senior unsecured and subordinated notes. The ANZ senior unsecured deal was the largest ever in the domestic credit market. These deals were broader priced than the recent issuance and offered a substantial premium over leading pre-COVID bank spreads. As banks begin to refinance their guaranteed capital through the Term Funding Facility, we expect the pace of major bank issuance to accelerate. These deals are indicative of the trend we expect to continue as high quality issuers enter the market offering more attractive spreads to service their debt.
While there are substantial risks to trade in the current market environment, we remain confident that our portfolios are well positioned to remain resilient. At the same time, as yields rise, we see great investment opportunities with quality issuers at attractive levels.