The Reserve Bank of Australia (RBA) has hiked interest rates +400 basis points (bps) in the current cycle, taking the cash rate from emergency policy setting of 0.10% in April 2020 to the current rate of 4.10%, the most aggressive rate hike cycle under the prevailing monetary policy setting regime. Over a similar period, Australia’s inflation rate (core CPI) climbed from -0.3% YoY (June-20) to +7.8% YoY (Sept-22), levels not seen since the early 1990’s. The most recent core CPI print was +6.0% YoY (Jun-23). Excluding volatile items, trimmed CPI has eased to +5.9% YoY (Jun-23).
While inflation has eased back from 30+ year peaks, the prevailing run rate remains well outside the RBA’s target range of +2.0% - 3.0%. The RBA’s August Statement of Monetary Policy indicated the bank does not expect inflation to be back within target ranges until late 2025, two years away. The trend in inflation is lower, however there remain risks to inflation either re-spiking or lingering at elevated levels longer than expected.
Risks to lingering or rising inflation over the foreseeable future include rental and housing costs, which account for approximately 30.0% of CPI and is running at +8.09% YoY. With the threat of increased taxes on rental properties and caps on rental increases, investment is waning, threatening rental supply, which in turn exacerbates the problem. House prices are recovering rapidly and elevated building costs and increased immigration are also contributing to systemic imbalances. Wages growth remains a risk locally also as unions and workers agitate for cost-of-living adjustments threatening a wages-price spiral. Labour markets are showing signs of slack, but also proving to be remarkably resilient with unemployment near multi-generational lows, at 3.7%. The trend is higher, but gradually and still expected to remain well below long run averages (5.6% post the financial crisis).
Globally, with the lingering conflict in Ukraine threatening European energy security heading into the Northern Hemisphere winter, gas futures are spiking. We’ve also seen a +21% rise in crude prices over the past 1-2 months. Energy costs are global, impacting transportation costs and manufacturing costs, which would be a headwind also for local inflation.
Inflation is easing, but is it easing rapidly enough and is monetary policy restrictive enough to ensure no flare ups, all the while managing a soft landing?
So far, apparently yes – but there are risks inflation remains stubborn and lingers above the RBA’s target range for longer than currently expected. Nevertheless, for now the consensus view is that interest rates are either at, or close to their terminal rate (peak cash rate in the cycle). There is some speculation on whether the cycle is done (at 4.10%), or we have one more hike left in the cycle (to 4.35%) – the weight of numbers between these two views is somewhat balanced. There is a less popular, but still plausible view, that there are two more hikes in the pipeline (to 4.60%).
Is now the time?
Within an investor’s fixed income allocation, is now the time to consider adding duration risk, or is it “too soon?” If so, what are the alternatives? Below we consider the point of indifference between switching from floaters to fixed in a bid to capture duration benefits. We also consider return expectations between various interest rate-based asset alternatives. Namely, RMBS vs Corporate, and investment grade vs sub-investment grade.
Fixed Income Alternatives: Pros and Cons
For the sake of this exercise, we have assumed a modest-to-high-credit-risk appetite (within the context of fixed income as a defensive asset class) and looked at the following two broad options:
1. Fixed rate credit (duration & credit spread risk)
2. Floating rate credit (credit spread risk)
Before looking at each of the above two broad alternatives, some assumptions on interest rates, credit spreads and investment time horizon. We have assumed a one-year investment horizon – anything longer is pie in the sky given uncertainties around inflation and monetary policy settings. For underlying interest rates we have used forward market pricing of the RBA Cash Rate as a proxy for rate movements. Prevailing credit spreads are on or around their long run averages, and expected to range trade over the year ahead. For our best-and-worst-case scenarios we have used +/-25 bps movements relative to the base case through time.
1. Fixed Rate Credit
For the sake of this analysis, we have chosen BBB band rated fixed rate securities. The BBB band is the lowest investment grade band within the rating spectrum. For some risk context, over a five-year period, the cumulative default rate for the BBB band is anywhere between 0.90% (BBB+) and 2.63% (BBB-). For BB+, the first sub-investment band on the spectrum is 3.35%. Note, these are ‘corporate’ default rates.
We have used the ‘Bloomberg AusBond Credit ‘BBB- to BBB+’ Index (FXD)’ to set the investable universe. The index has 120 individual fixed rate bonds totaling $38bn market value. The weighted average yield of the index is 5.68% (4.55% - 8.02% range) and the weighted average coupon is 3.45% (1.20% - 6.50% range). The index has a weighted average duration of 3.84 years (modified duration). We have not considered private loans, as we do not like their risk dynamics, namely they’re typically unrated and very illiquid (not traded).
Over the last 12 months (to the end of July) the mentioned index has returned +3.84% (or +4.17% CYTD). For downside risk, the COVID impact (Mar-20 economic shot down) resulted in spreads doubling, or widening +110 bps, from +108 bps to +213 bps. The marked to market impact from this was -4.50%, the worst monthly loss in the BBB space over the past seven-years. Over the 2022 calendar year the index lost -8.92%, while the financial year ending June 2022 saw a loss of -11.10% as the RBA hiked rates. The index has delivered a negative monthly return 27% of the time since 2013 (i.e 29 months out of 108).
Outlook: short of a systemic shock, credit spread stability is assumed over the coming year. Spreads are currently on or around their 5-year averages and expected to range trade. Accordingly, the primary driver of performance will be underlying yields. The outlook for yields is challenging given the inflation back drop and expectations of official cash rates remaining elevated for a prolonged period of time – well into the back half of 2024. Previous interest cycles have seen the gap between the last rate hike and first rate cut average around nine-months, yet the previous cycle saw the gap out to 18 months.
Expectations for this cycle are at least 12 months before we see the first rate cut.
Expected returns for BBB credit over the year ahead
2. Floating rate credit
Comparable securities in the ‘BBB’ band include major bank tier 2, or subordinated debt, which is rated BBB+, and the BBB rated tranche of RMBS structures. The most recently issued major bank tier 2 was from CBA, which priced at +230 bps for a 5Y call and is yielding 6.5%.
In the RMBS space, the BBB tranche of non-conforming deals is yielding around 8.5%, or BBSW+450 bps, but with a shorter weighted average life of 3.5 years vs 5.0 years for the above tier 2 line. Despite RMBS being shorter tenor, there is some +260 bps of spread pick up in holding RMBS over major bank tier 2. Why? While each carries similar credit risk, the varied trading dynamics (liquidity), RMBS attracts a liquidity and complexity premium over the tier 2.
Tier 2 paper is actively traded, although can go through periods where paper is hard to come by. The best avenue to gain exposure is through primary, but secondary is available for a price. While RMBS is ‘illiquid’ in the broader scheme of things, it is nonetheless traded (unlike private loans) and independently priced.
Downside risk during events of market dysfunction is less clean cut, major bank tier 2 is not included in any index, nor are RMBS securities. Accordingly, we have used Mutual’s own funds as proxies, the Mutual Income Fund (‘MIF’) for tier 2 (~60% of FUM) and Mutual High Yield Fund (‘MHYF’) for RMBS (~90% of FUM). At its worst during COVID, MIF lost -2.1% in March 2020, while MHYF lost -2.5%. Losses were recouped within four and six-months respectively.
MIF has generated a negative monthly return 12% of the time (2013 – now), i.e. 15 months out of 124. All but 2 of these months were during COVID. Average downside excluding the initial market sell-off was modest at -0.19%. Since inception, MYHF has generated negative return months 11% of the time, i.e. 6 months out of 54, all of which occurred on or around the onset of COVID.
Return framework follows, firstly we have the 1Y return matrix for major bank tier 2 given various BBSW and spread change scenarios.
* Assumes changes move over 6-month and 3MBBSW reverts to historical average after two years.
** Note higher credit spread reinvestment rates take time to filter through to returns, hence initially lower 1-year returns.
BBB major bank tier 2 paper vs BBB fixed rate corporate? Pros and cons? Liquidity first - major bank tier 2 is arguably more liquid than BBB fixed rate corporate paper, with banks ‘generally’ supporting their own paper during periods of market dysfunction. Duration of the fixed rate bonds is attractive on the surface, ‘if’ we are in fact at the end of the hiking cycle. Such is not a given. The risk of getting duration wrong can be meaningful.
Fixed rate credit return volatility (monthly) is historically 3 – 4 times more volatile than floating rate credit returns. With expected returns on BBB fixed corporate credit around 6.00% - 6.25% versus similar returns for major bank tier 2 (rated BBB+), an investor should be indifferent between the two on a return only basis. However, if we adjust for risk, tier 2 paper is a better alternative.
Tier 2 relative value is also attractive, per the following, offering a more attractive spread than the bulk of the BBB index.
Source: Bloomberg, Mutual Limited
Switching to RMBS. RMBS spreads are at their pre-and-post pandemic wides, and likely long run historical wides also. Looking down the capital stack, the spread on offer for ‘AAA’ rated tranches is around +170 – 190 bps, offering a yield / coupon around 5.70% - 5.90%. ‘AA’ rated tranches offer +300 – 350 bps or 7.00% - 7.50%, ‘A’ rate tranches 400 – 425 bps or 8.00% - 8.25%, ‘BBB’ rated trances offer +450 – 475 bps or 8.50% - 8.75%, while the sub investment grade tranches offer +750 – 900 bps, or 11.50% - 13.00%.
Spreads have widened in the past 6 months on arrears concern and risk of falling house prices. The latter have stabilized and risen off their recent troughs, with consensus forecasts pointing to +5.00% - 7.00% growth over the coming year. Market technical – supply and demand dynamics – remain favourable for continued price stability. Arrears have risen as the RBA has hiked rates – which is to be expected - however in the past 2 – 3 months, arrears have stabilized and actually reversed course as households adjust to the higher rate settings. Low unemployment has also contributed to arrears strength, which remains well below long run averages.
The following table displays return possibilities for ‘BB’ rated RMBS given changes to 1MBBSW and traded margins.
Data: Bloomberg, Mutual Limited
* Assumes changes move over 6-month and 1MBBSW reverts to historical average after two years.
** Note higher credit spread reinvestment rates take time to filter through to returns, hence initially lower 1-year returns.
Given the return outlook for both major bank tier 2 and RMBS, the following table displays return possibilities for the Mutual High Yield Fund given differing BBSW and spread scenarios.
Data: Bloomberg, Mutual Limited
Assumes changes move over 6-month and 1MBBSW reverts to historical average after two years.
** Note higher credit spread reinvestment rates take time to filter through to returns, hence initially lower 1-year returns.
Note, an important characteristic of RMBS vs say tier 2 is that after a period of time, typically somewhere between 6 – 12 months, RMBS tranches begin to amortise. This reduces risk and generally, within 18 months of issuance (historical average), results in the tranches being upgraded by the rating agencies.
Lastly, no rated RMBS tranches has ever incurred an uncured capital loss. Further, the underlying loss rate from mortgage lending across the non-bank lending sector has averaged less than 0.10% since inception.
In conclusion
Starting with a question, is now the time to add duration risk over say floating rate credit? In short, we think there is time to make that call. Whether we’ve reached the peak of the interest rate cycle is still a matter of debate. Yes, we’re near the top, but there is the risk rates will go higher. The market view is that interest rates will stay elevated and flat over the year ahead. Perhaps decline marginally toward the end of next year, as indicated in the first of the following two charts. Within this environment capital gains would not represent a significant contributor to overall returns, with carry (or coupons) likely to be the core return contributor.
The risk to this view is if the economy slows more rapidly than currently expected and we see a meaningful spike in unemployment. Such would likely trigger a dovish turn in monetary policy settings, resulting in a fall in yields (capital gains). Not the consensus view, but a scenario that can’t be entirely discounted. Still, an unlikely turn of events. Alternatively, we witness lingering inflation with further rate hikes deemed necessary. In this environment, floating rate securities offer relative immunity to duration risk, protecting capital, while still delivering income to support total returns.
Market Terminal Rate Pricing
Data: Bloomberg, Mutual Limited
The first rate cut from the RBA is not realistically priced in until the back end of 2024, possible early 2025. Since 2000, underlying yields (ACGB’s) have traded at a margin to the cash rate of +11 bps for 3Y ACGB’s and +60 bps for 10Y ACGB’s. Assuming mean reversion here, the prospect of capital gains from falling yields over the year ahead is low to modest.
ACGB Bond Yields vs RBA Cash & CPI
Data: Bloomberg, Mutual Limited