Fixed Income
Matthew Clunies-Ross

One of the advantages about marketing and managing a corporate bond fund in Australia, is the amount of people we meet which gives us the opportunity to listen to their concerns about different asset classes and markets. Presently at Artesian, the most common questions we get asked are in relation to investors' concerns about the recent growth in the US BBB corporate bond market.

There are always implications for investors when there is exponential growth in a particular part of the global debt market (think sub prime in 2008 as an extreme example) and it is only natural for investors to be asking questions. The growth of the US BBB market and the causes of that growth, have been widely discussed. However, how this affects the Australia corporate bond market and what the key differences are between these markets has been largely ignored. In this wire we will attempt to define those comparisons and provide some insight into the opportunities offered by the Australian corporate bond market.

The Australian and US corporate bond market – how are they different?

The Australian corporate bond market ("Australian market"i) is a tiny market in comparison to the US corporate bond market ("US market"ii). The US market as at 31st March 2019 was USD 6.58 trillion compared to the Australian market USD 0.19 trillion. 

With size comes liquidity, obviously a very important feature of any asset class. However, in the case of the global corporate bond market, with liquidity comes volatility.

In times of heightened volatility the ability to sell or trade assets at realistic levels (defined broadly as liquidity) can become problematic. In general, in most corporate bond market environments, buying or selling AUD 1m to 2m of corporate bonds is not hard. Try and sell AUD 20m to 50m of bonds however and all of a sudden most market makers are either in a meeting, out for coffee or at lunch.

In 2018 there was a pick-up in corporate bond credit spread ("spreads") volatility. There were moderate sell offs in February, March and July and a sustained sell off in November and December. The chart illustrates that spreads in the US can move quite dramatically when compared to spreads in Australia. This is because the Australian institutional investor base is predominately buy and hold – they sell corporate bonds as a last resort as they fear not being able to buy them back when volatility subsides.

In addition, the argument could also be made that there is more risk in the US market so therefore the US market should trade at an elevated beta when compared to the Australian market. US spreads were 1.6x more volatile over the period, yet the mean US spread was only 1.1x higher. So risk adjusted and ignoring the additional risks of investing in foreign currencies (for Australian based investors potential currency hedging required), the Australian market comes out on top.

The Australian and US BBB corporate bond market – how are they different?

It is useful to begin by looking beyond the headlines at some of the significant differences between the Australian and US corporate bond market. In particular "crossover" corporate bonds, which overlap the line between the investment grade and high yield bond markets. This sub-sector of bonds includes the lowest rating investment grade bonds (BBB+ to BBB-), down to the highest rating non-investment grade bonds (BB+ to BB-).

One of the greatest fears (other than a credit default) of any investment grade corporate bond investor, is that their exposure to a BBB- corporate bond gets downgraded one or more notches and crosses over to non-investment grade. This usually leads to forced selling by institutional investors because the corporate bond may no longer meet the minimum standard credit rating. Additionally, these corporate bonds may also fall out of investment grade indices which ETFs track, and hence more forced selling.

This is a valid concern – but should Australian dollar investors have the same concerns?

BBB rated bonds in the US ("US BBB market"iii) as a % of the total US market is a whopping 57.5%. Significantly higher when compared to the BBB bond weighting in the Australian market ("Australian BBB market"iv) of 23.9%.

The Australian corporate bond market in totality has only really come of age in the past 4 years, as volumes, number of unique issuers and number of new deals are all showing signs of growth. Over the same 4 year period the Australian BBB market has grown 6%, compared with growth in the US BBB market of 42%.

Investors’ worries are based on the size of the outstanding debt – combined at the same time with the prospect for downgrades in a weakening economy. These concerns in the US are valid, investors with exposure either directly, via and ETF or via a managed fund should evaluate how much of this risk they have versus how much of this risk they actually want.

It is also important to note that we are discussing 'mark to market' risks and not default risks. In addition, unlike equities and most hybrids, corporate bonds are not perpetual securities as they have a known maturity date. 

What (and when) to look for when assessing corporate bond markets

When analysing corporate bond markets we firstly look at the macroeconomic backdrop, secondly the underlying dynamics of each market and lastly the fundamental credit quality of issuers. Credit performs best in the recovery stage of the economic cycle and worst in a recession. Whilst we believe we are not at the end of the current expansionary economic cycle, it’s safe to say we are closer to the end than the beginning. As we advance in the current economic cycle, investment decisions regarding credit naturally become harder.

Comparatively speaking, there are levels of comfort that can be attained by looking at the credit fundamentals of the Australian market and the very strong technical support. There is always the option in uncertain times like these to invest in a manager that is mandated to take less risk than a market beta fund does. This is well accepted in the equity fund manager world, but probably hasn’t been as well understood in the corporate bond market – as the market is new and growing in Australia. Right now in Australia, we believe that the Australian market is very attractive for that reason. New and growing markets offer great opportunities for the nimble investor and total return fund manager.

The fears regarding the US credit market are based on a combination of the economy slowing faster than expected and supply worries. In a worst-case scenario (for example some large BBB issuers being downgraded to non-investment grade) contagion will be felt in credit markets globally. However, we expect this will be to a much lesser degree in Australia because of the credit quality of the Australian market and the buy and hold nature of the Australian investor base. With volatility comes opportunity, and to take a positive viewpoint, if you are positioned to take advantage of the pricing moves (not tied to an Index) then greater returns are also possible in the long term.

The implications for the price of this debt if the US did fall into a recession are great. The performance of the US market was indeed poor for 2018, spreads were 54bps wider mainly due to the last few months of the year when credit spreads in the BBB segment deteriorated causing losses. At the same time Australian spreads were 22bps wider, outperforming the US market considerably. So to be clear, the Australian and US credit market are not apples and apples – more like a watermelon and a pebble. One is huge and can crack under pressure, whilst the other is small and firm.

Let’s state the reasons why we can afford to be more sanguine in Australia 

  • Less BBB issues means lower risk – as we have already outlined, compared with the US market the Australian market has considerably less BBB debt on an absolute and weighted basis. Therefore, in Australia it is easier to build a diversified portfolio with a moderate allocation to BBB debt. However, in the US you could argue the task becomes more difficult because of the sheer size of the BBB sector. A US market neutral or index managed fund would naturally have very large BBB exposures and would potentially have great difficulty in reducing these risks. As an investor you would ride this wave to the fullest. Downgrades (if they happened), liquidations and general market weakness would all impact returns negatively. By the same token if the backdrop improved these funds would perform very well. Watermelons in summer are delicious.
  • High credit quality – corporate credit quality of bond issuers in Australia is on average a lot better, with 76% of the Australian market rated A- or higher. This reflects the strength of the credit fundamentals in the domestic market. It also provides a greater 'cushion' between the average investment grade issuer’s credit rating and non-investment grade. This cushion is extremely important from both the market and the issuer’s perspective. As an extreme example, in the US we have seen the deterioration of the once AAA rated General Electric (GE) now rated BBB+. Not only is this one of the largest bond issuers in the world, it has been moving at a steady pace towards junk (sub-investment grade) territory. GE has three bonds in AUD with a total volume of AUD 900 million, compared with their USD issuance which totals USD 113.5 billion! GE’s AUD bonds (we don’t own them) are currently bid only with none on offer. This compared with their USD bonds which you can pretty much name your size and maturity preference and hit the trade button. Clearly there are different market dynamics at play here.
  • Blue chip opportunities – it is also important to note that in addition to the Australian market, investors now also have a multitude of global blue-chip companies AUD bonds they can invest in. You can have a 'global' fund now without leaving the comfort of home and the Australian dollar!
  • Buy and hold market – the Australian market is categorised as more of a 'buy and hold' investor base, due to the fact that there aren’t enough bonds to go around for the natural holders like large superannuation funds. It is hard once a corporate (non-financial) issue is sold from a portfolio to buy it back in the future. This is an important technical support for the Australian market. The US market has a different dynamic – it is large and liquid so investors don’t fear being able to buy bonds back in the future. They sell on market moves which causes volatility in spreads and mark to market values in investors' portfolios. However, the good news in Australia is that there just isn’t enough of the good stuff (high quality corporate debt) to start selling in volume the moment the wind changes direction – hence the inherent out-performance and markedly lower volatility in returns. 

In conclusion

There is a safer alternative to many of the assets that fall under the 'credit' umbrella. The quest for yield has opened up many new markets for Australian investors, such as leveraged loans, structured credit and bank hybrids to name but a few. But given the attributes of the nascent Australian corporate bond market, there is now a potentially safer and more rewarding alternative to risky or foreign bond markets. Investment grade Australian dollar corporate bonds can offer an attractive return with a lot less volatility and risk, than other credit assets.

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Disclaimer

Important information: All investing is subject to risk, including possible loss of principal. Investments in bonds are subject to interest rate, credit, and inflation risk. Opinions expressed in this article are those of the author, and are not a recommendation to invest. This paper includes general information only. The information has been prepared without taking into account any individual's personal objectives, financial situation or needs. Past performance is not an indication of future performance. This publication was prepared in good faith and we accept no liability for any errors or omissions.

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i)  Defined as investment grade AUD corporate bonds, Bloomberg country of incorporation is Australia as at 31.03.19.

ii) Defined as investment grade USD corporate bonds, Bloomberg country of incorporation is the US as at 31.03.19.

iii) Defined as BBB USD corporate bonds, Bloomberg country of incorporation is the US as at 31.03.19.

iv) Defined as BBB AUD corporate bonds, Bloomberg country of incorporation in Australia as at 31.03.19.



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