With the prospect of higher inflation, accelerated by the threat of a protracted war in the Middle East, shifting interest rate expectations, it’s not an easy time to be investing or positioning your portfolio to ride highly volatile markets.
With energy-fuelled inflation shocks casting a major shadow over fixed interest and bond markets, Azzet took a look beyond the market noise for a clearer picture of what’s really going on.
Firstly, let’s take a look at what’s been happening on the ground.
Spiralling oil prices, courtesy of the Middle East war has sent oil prices soaring and caused a sharp upward repricing of bond yields, which suggests investors now expect "higher for longer" interest rates to combat the war against sticky inflation.
Remember, whether rising yields are good or bad depends on what you’re doing as an investor.
For new investors, rising yields mean you can buy bonds at a discount and receive higher annual interest (yield) than before.
However, if you’re an existing bondholder, rising yields mean the market price of your current bonds drops, and if you need to sell before they mature, you’re likely to lose money on the principal.
Current yields
While the 5-year Commonwealth Government Bond (CGB) is currently yielding around 4.72%, major bank subordinated (tier 2) debt in the commonly issued 10-year callable-at-5 structure is offering an-in yield of around 6.38% for fixed-rate issuance, with the 5-year swap at 4.93% and T2 credit spreads running around swap plus 145 basis points.
Meanwhile, on a floating rate basis, with 3-month bank bill swap rates (BBSW) at 4.30%, equivalent paper – AKA annualised return (yield) of a similar financial security - is yielding around 5.75%.
Interestingly, these numbers are by no means low when set in a historical context.
When plotted over the last two decades, we are sitting comfortably toward the upper end of the historical range.
The only sustained period where CGB yields were higher was the pre-GFC era, when the 5-year bond was trading above 5.50% and ultimately peaked near 6.45% in mid-2008 when the rate environment was driven by a fundamentally different inflation regime and global growth backdrop.
Overall, today’s yield environment is as attractive as Australian fixed income investors have seen in a generation.
Priced for comfort
When we take a closer look at the current spread narrative, what becomes clear is that Australian Banks are priced for comfort as opposed to crisis.
As a case in point, T2 subordinated debt from the major Australian banks is currently trading at around 165 basis points over the CGB - with the 5-year swap at 4.93%, and T2 ASW credit spreads at around 145 basis points.
That's a long way from the crisis peaks of 285 basis points during the 2022 supply surge and the 300 basis points hit at the height of COVID.
The current spread level reflects a market that is pricing Australian bank T2 as genuinely high-quality credit, and Jon Lechte, CEO at Income Asset Management, believes it is fairly valued given the fundamental strength of the institutions behind it.
Part of what distinguishes the Australian T2 spread from comparable offshore markets, explains Lechte, is the credit rating underpinning it.
Australian major bank T2 subordinated debt carries investment grade ratings of A-/A3/A- (S&P/Moody’s/Fitch), a full rating category above the BBB range where U.S. bank subordinated debt typically sits.
“That rating differential directly reflects the superior capital position and regulatory framework of the Australian major banks and is explicitly priced into the spread: tighter spreads here are not a function of investor complacency but of demonstrably lower default risk,” said Lechte.
What’s also created a greater focus on T2 subordinated debt is the phasing out of AT1 hybrids, with around $40 billion of AT1 outstanding across the major banks currently being wound down as instruments reach their first call dates.
Around 75% of that capital is expected to be replaced by additional Tier 2 during the phasing out of AT1 hybrids, with the sector needing to bring significantly more subordinated debt to market than historical run-rate volumes would suggest.
Fixed-rate yields look attractive
For those who believe that we are at or near the top of the rate cycle, Lechte reminds investors that locking in current fixed-rate yields looks attractive.
“A 5-year CGB at 4.72%, or a major bank T2 instrument at around 6.38% all-in fixed, represents investment income that could not be accessed for the better part of a decade,” he said.
However, he also reminds investors that geopolitical risk is real, with the inflationary impulse from the Iran conflict yet to fully wash through supply chains.
Given that rates could push higher from here before they settle, Lechte does not recommend going fully fixed.
“Depending on your personal view on rates – hold 40–60% of your fixed income allocation in floating rate instruments for now,” he suggests.
“If yields push higher, your income rises with them. The fixed portion locks in today’s historically attractive rates. The floating portion keeps you flexible.”
Meaningful tailwind
What floating rate securities give you is rate optionality.
For example, the current BBSW of 4.30% versus a 5-year swap of 4.93% offers a 63 basis point premium to fixing.
Locking in fixed yields today comes at a meaningful price relative to floating rate equivalents, which Lechte suggests warrants a considered rather than wholesale shift to fixed.
There is also a technical case supporting Australian duration.
Lechte also reminds investors that the spread between 10-year Australian government bond yields and U.S. Treasury yields has widened to around 70 basis points, while the recent underperformance of Australian yields relative to their U.S. counterparts looks somewhat overdone on a historical basis.
“While trend pendulums always tend to test investors’ nerves, this dynamic provides a meaningful tailwind for the fixed component of a barbell portfolio and supports holding at least 40% in fixed-rate instruments, even for investors who remain cautious about the near-term domestic rate outlook.”
