Australian credit spreads provide great opportunities but maintain quality
The patience of investors in more credit oriented fixed income funds has been sorely tested over the last 12 months. For such investors returns have been challenged by not only rising interest rates but also widening credit spreads. Yet there is a silver lining behind such negative returns as they signal a return to more normal financial conditions and provide, in turn, the opportunity for higher returns going forward.
One of the core sources of return enhancement within most fixed income portfolios is the incorporation of a structural overweight to credit spreads[i]. Such an overweight aims to access one of the more predictable premiums which can be earned in fixed income markets. This is especially true in markets such as Australia where the credit exposures tend to be relatively ‘high quality’; i.e. exhibit low absolute levels of default risk. Yet this underlying belief in the benefits of a strategic overweight to credit has been challenged over the last couple of years as investors experienced low headline yields over 2020 followed by material negative returns from 2021-2022.
The material negative returns generated in bond markets has been largely attributable to the changing dynamics within fixed income markets. This alteration in dynamics is largely due to the change in the approach to implementing monetary policy by many central banks associated with the adoption of quantitative easing (‘QE’). Under QE, rather than simply altering the official cash rate, central banks provide liquidity to the financial markets by intervening directly and purchasing securities. QE can therefore be considered as a ‘non-traditional’ approach to setting market interest rates to distinguish it from the more ‘traditional’ approach of altering the official cash rate. QE as an approach to implementing monetary policy becomes a more important policy tool as (a) official cash rates approach particularly low levels and/or (b) central banks need to target policy towards specific parts of the financial system.
Moving to a QE approach to implementing monetary policy results in market dynamics changing as central banks are now directly intervening in financial markets to bring around desired outcomes. Critically movements in credit spreads are no longer simply a by-product of the central banks use of monetary policy to “lean” against the traditional economic cycle. Rather, credit spreads are being used directly by central banks as a specific target of monetary policy and a lever by which to implement and maintain accommodative monetary policy. With both interest rates and credit spreads being specific targets of monetary policy then the more accommodative monetary policy the lower both interest rates and credit spreads due to the direct intervention of central banks. Conversely, less accommodative monetary policy delivers both rising credit spreads and interest rates. It follows that under such a ‘non-traditional’ framework for implementing monetary policy investors will find that as central banks lower and then raise interest rates the interlinkage between bond yields and credit spreads will differ materially from what would traditionally be expected. Rather than the negative correlation which investors may be used to, under a non-traditional approach to setting monetary policy there will tend to be a positive correlation between interest rates and credit spreads. This volatility has been particularly noticeable for investors in many more credit-oriented products who have been hit by the ‘double whammy’ of rising bond yields and credit spreads over the last 12 months.
While the normalisation in monetary conditions has created pain for investors over the last 12 months it has also provided opportunities. Nowhere are the opportunities more apparent than in terms of Australian investment grade credit spreads which have materially increased. This increase in credit spreads is partly driven by the direct actions of the Reserve Bank of Australia (‘RBA’) to normalise interest rates. Also driving the increase in credit spreads is the expectation of a material increase in new issuance by Australian banks as the direct funding provided by the RBA under the Term Funding Facility runs off over the next couple of years. A by-product of these dynamics is that, at a headline level, investors can now lock-in some of the highest credit spreads seen in the last decade.
Yet despite their apparent attraction there are solid grounds for investors being selective regarding the approach taken to adding to their credit spread exposures. Just why investors should remain selective can be seen by considering the two principal ways that an increase in such exposures can be achieved.
Investors wanting to add to credit spread exposures may be tempted to move down the credit quality spectrum into lower rated and/or more subordinated issues. Unfortunately, the flipside of a return to more normal monetary conditions is not without risks as even central bankers are unclear as to the impact higher official cash rates will ultimately have on underlying economic conditions. Such uncertainly is likely to manifest itself as heightened investor concerns regarding the risk that economies may go into recession. These recession risks are likely to grow should central banks, such as the RBA, feel that materially higher official cash rates are required to curb inflationary pressures. Against such a backdrop, investors wanting to take advantage of higher credit spreads should remain wary of moving too far down the quality spectrum within their portfolios. Even if the outright risk of default is small, lower quality issues may be at a heightened risk of ‘mark to market’ losses in the event of a liquidity driven selloff in credit spreads; i.e. material increase in investor risk aversion.
Another means of adding to credit spreads is via longer dated credits but even here investors need to remain wary as interest rate duration is still a bit of a two-edged sword. On the one hand the backup in bond yields has provided investors with greater protection against a policy mistake by central banks and the potential risks of a recession. On the other it is not yet clear that central banks are ahead of the inflation curve. This creates the risk of a further upward move in bond yields should central banks feel the need to increase cash rates by materially more than the market is currently expecting.
Despite the recent poor returns, the normalisation of monetary conditions by central banks has provided some of the best opportunities available from more credit oriented fixed income products for some time. While it may be tempting for investors to ‘pile in’ to higher risk products to take advantage of higher yields the threat of a policy mistake by central banks should not be overlooked. At this point in the cycle the risk of policy mistake would appear to be finely balanced between recession on one hand and falling behind the inflation curve on the other. Against such a backdrop, while adding to credit spreads is attractive, investors should remain wary regarding the type of credit exposures they are adding to their portfolios. The old saying ‘everything in moderation’ may yet prove the best way forward.
[i] Credit spread is broadly defined as the additional yield earned over the Australian government bond yield as compensation for the increased default and liquidity risk assumed by the investor. It should therefore be considered as the additional risk premium required by investors.
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Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...