Steeper yield curve brings a flood of opportunities

With the now familiar ‘reflation trade’ (one of the more overused terms of 2021!) now evident, the resulting steeper interest rate yield curve is providing a happy hunting ground for credit investors. This is especially the case for investors with minimal interest rate duration in their portfolios because their returns are linked to movements in the cash rate.

At a cash rate of just 0.10% and the Reserve Bank of Australia (RBA) committed to no rate hikes until 2024, the multiple of the yield differential to risk-free 10-year government bonds (around 1.5%) is clearly unlike anything observed in the Australian market over the past 20 years, exploding from being consistently below 1-times to as high as 18-times over the last 12-18 months (see Chart 1). This very elevated multiple increases the opportunity for credit investors like us to return hurdles to cash without taking undue credit risk.

When you add an approximate 1.50% in credit margin to risk free for longer dated corporates, the yields of around 3% on offer for quality investment grade (IG) issuers looks very attractive indeed against a cash rate at just 0.10%. Within our own portfolios, recent investments in the BBB+ rated REIT ‘Lend Lease International Towers Sydney Trust’ (LLITST) 9-year bonds at a 2.85% yield and the BBB+ rated toll road ‘Westconnex’ 10-year bonds at 3.19% were both attractive additions (refer Chart 2). 

After stripping out duration on these and other names, we are easily meeting our own 2.5-3.0% return hurdles (to benchmark). And, importantly, despite performing strongly over the past 12 months we believe corporate credit margins remain fairly valued.

In recent months we’ve discussed at length the damaging impact the RBA’s Term Funding Facility (TFF) has had on major bank senior credit margins. That said, as a multiple of bank senior, high quality BBB corporates continue to trade at roughly twice their pre-pandemic multiples, providing confidence that valuations will remain fairly priced even after, as expected, bank senior credit margins normalise (post TFF) in the second half of CY21 (refer Chart 3).

We continue to take advantage of market conditions and have increased the proportion of fixed rate exposures (hedged) in our portfolios, highlighting the benefits of maintaining a flexible approach. Both the Yarra Enhanced Income Fund and Yarra Absolute Credit Fund continue to yield ~3.5% from their average investment grade portfolios. 

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