Where we see the best value in credit markets as inflation returns

As equity market volatility rises and inflation returns, bonds – global and domestic, corporate and government – are once again on investor radars.

After the Reserve Bank of Australia last week lifted the official interest rate to its highest level in a decade, in the following interview, I provide our view on where inflation and interest rates are headed. I also outline which parts of the credit market are likely to provide the best opportunities.

Following the widely anticipated rate rise, the cash rate now sits at 0.35%, as the central bank seeks to control core inflation that has exceeded the target range of between 2% and 3%.
Where will it end? In Australia, from the current level of between 3.5% and 3.7% for core inflation, I expect this will rise to 4.5%.

Contrasting with the US, where headline inflation is 8%, core inflation is 5.2%, and wages are running at 4.5 – 5%, Australia remains relatively stable. The urgency is much less for the RBA, which is in a relative position of strength.

And both markets have priced in cash rates of between 3.5% and 4% next year, which we believe is too much. In Australia, this would see mortgage rates rise to between 5.5% and 6% – a trade-off the RBA won’t be willing to make.

In the following interview, I explain:

  • how the pricing of bonds is likely to shift over the next year, and why
  • the concept of risk premia, and
  • where we see the best value in fixed income.

This includes corporate bonds offered by four well-known Australian REITs and two key infrastructure assets.


Edited transcript

Hugh Holden: Well, hello, I'm Hugh Holden. I'm joined today by portfolio manager Aaditya Thakur, and we have lift off. At its may meeting the Reserve Bank of Australia raised the official cash rate for the first time in over a decade, by 0.25% ­– that takes it to 35 basis points. And that was off the back of a higher than expected inflation print for the first quarter, which also took Australia's year on year inflation rate above the Reserve Bank's target range of two to 3%.

So Aaditya, the first cash rate rise in over a decade, inflation running above target: is the Reserve Bank now behind the curve and are they going to have to move really quickly to try to get on top of things?

Aaditya Thakur: Yeah. So when central banks raise interest rates, they're willing to give up a little bit of growth to curb inflation. So, in terms of the pace of hikes that are required, it really depends on the degree of inflation overshoot. So when we look at the data underlying inflation is now at 3.7%. It's expected to rise to around 4.5%, wages are running at between 2 and 2.6% expected to rise to the low threes. And that's relative to the top end of their target band of 3%. And in the context of fairly stable inflation expectations. Now contrast this to the Fed where headline inflation is 8%, core inflation, 5.2% and wages running at a hot four and a half to 5%.

Hugh Holden: That's in the US.

Aaditya Thakur: That's in the US. So, and that's relative to a lower inflation target of 2%. I think the urgency is much less for the RBA. They're in a position of strength on a relative basis, and that can afford them the ability to raise rates at a standard pace, say 25 basis point increments over the next few meetings.

Hugh Holden: That’s the pace to expect over the next few meetings, but what about the end point? How high do we see rates moving?

Aaditya Thakur: Yeah, I think this is the more interesting question. When we look at the first slide, when we compare Australia and the US, given that they've got quite different inflation overshoots, both markets are priced in for cash rates to reach almost 3.5% by the middle of next year. So in Australia, in particular, we think that that's too much. To get cash rates there would imply mortgage rates would move to between 5.5% and 6.5%.

And we think that would be too much of a negative impact on consumption and house prices and a tradeoff that the RBA won't be willing to make under this kind of inflation outlook. So, we expect them to raise rates to around 2.5%.

We think that gap between our expectation and market pricing is more a reflection of risk premia rather than a genuine expected move in the cash rate. And when we think about that risk premia, it's really extra compensation investors want due to elevated volatility, due to inflation, central bank uncertainty and COVID.

Now, if I can kind of cast everyone's mind forward three to six months, we would've had a few hikes out of the way. So, uncertainty around central banks will be reduced. The inflation outlook, it's likely the inflation would've peaked and we'd have better clarity on the inflation trajectory and COVID is that much further behind in the rear view mirror. So, I think that risk premia will start to come down and in the second half of the year, price action will be determined by valuations as opposed to volatility like in the first half of this year.

Hugh Holden: Okay. And then valuations, maybe that's a good final point. We have seen a big rise in yields. We've also seen credit spreads widening. So what sort of opportunities does that create?

Aaditya Thakur: Yeah, I think in the extreme volatility that we've seen, it's often easy to lose sight evaluations.

We think US Treasuries at around 3% and Aussie bonds around 3.5% are now constituting good value over the medium term. We're having a lot of encouraging conversations with clients, particularly those that have been underweight bonds to start reducing those positions. And that's something that we're looking to do in our own portfolios.

Secondly, when we look at the second slide and we look at valuations across other asset classes, and we look at what's changed, what's moved to incorporate this higher inflation, higher interest rate outlook, the one thing that stands out to us is investment-grade credit. Investment-grade credit spreads have widened a lot and they're offering some good value and bringing it back to Australia, we see value in subordinated debt in the major banks, in high-quality REITS, names such as Charter Hall, GPT, Dexus, Lend Lease. And also some key infrastructure-related assets, things like WestConnex and Transurban (ASX: TRS) in Queensland. All these bonds are now offering yields of 5% or above. And we think that constitutes really good value over the medium term.

Hugh Holden: As a bond manager, the advantage of that shift higher in yields being so rapid is that, of course, we're reinvesting coupon payments and proceeds from maturing bonds every day at those higher yields. It does benefit investors in terms of the yield on portfolios and forward-looking returns.

Hopefully, you found that useful. If you do have any other questions or want any more information, please visit our website at (VIEW LINK). Thank you.

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Portfolio Manager
PIMCO

Aaditya is a senior vice president and portfolio manager focusing on Australian dollar and global portfolios. He has 13 years of investment experience and holds a master's degree in commerce (finance) from the UNSW. He is also a CFA charterholder.

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