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Ticket to the ghost train

Investors are adjusting to a new normal in the Australian high-grade market as conditions settle after March’s turmoil. Reserve Bank of Australia (RBA) bond purchases slowed to a halt by the mid-way point of the year, but investors say its presence is still bringing stability and creating opportunities.

Matt Zaunmayr Deputy Editor KANGANEWS

The RBA stepped into the Australian government bond market in late March to ease trading conditions, which had deteriorated to the point of dysfunction. Between 20 March and 6 May, the RBA bought A$51.4 billion (US$35.7 billion) of Australian government and semi-government bonds.

Since early May, the central bank has ceased purchasing as it deems its two key objectives for unconventional monetary policy – a three-year Australian Commonwealth government bond (ACGB) yield of 0.25 per cent and general functioning of capital markets – are being met.

The Australian Office of Financial Management (AOFM) executed two record syndications in April and May, for an aggregate of A$32.5 billion, and regularly tendered around A$5 billion of government bonds each week from April to the end of H1. Semi-government borrowers have also issued record volume, indicating to the RBA that the market is functioning.

While government and semi-government bond yields were the first to react to the RBA’s purchases, in Q2 yield in other high-grade and credit asset classes progressively moved to levels lower even than before the pandemic (see chart 1).

The RBA will intervene if necessary. Its June monetary policy statement says: “The government bond market is operating effectively and the yield on three-year Australian government securities is at the target of around 25 basis points… The [RBA] is prepared to scale up its bond purchases again and will do whatever is necessary to ensure bond markets remain functional.”

Now the dislocation and spread widening of March-April has passed – at least for the time being – the Australian buy side is adapting to what is widely expected to be a protracted period of ultra-low rates. The challenge investors face is finding a positive return with an acceptable risk profile.

“The second ride on the ghost train is not as scary as the first. A lot of measures to support the market are now in place so, while there could be pockets of volatility, the outcome is unlikely to be as severe as it was in March.”

Opportunity set

There is still at least some juice even in the ACGB market. The RBA’s approach is to keep its intervention to a minimum but to make clear its willingness to be as active as necessary to meet its goals. This approach has facilitated stability but allowed market forces to dictate spreads outside the three-year ACGB. Investors say a relatively free-floating long end has opened up opportunities.

Anthony Kirkham, Melbourne-based head of investment management and Australia and New Zealand operations at Western Asset Management, says: “We know the three-year rate is locked down but the RBA has not really bought past 10 years. This makes the market fluid and susceptible to different outcomes, which we need when taking positions.”

The RBA’s actions have caused a steepening of the ACGB yield curve (see chart 2). Tamar Hamlyn, principal at Ardea Investment Management in Sydney, says: “The RBA’s yield target for three-year government bonds creates a point on the curve that is more or less fixed. As a result, the forward interest rates implied by government-bond yield are steep beyond three years. This can present some attractive relative-value opportunities.”

This opportunity extends into the semi-government sector, says Darren Langer, senior portfolio manager at Nikko Asset Management in Sydney. He expects semi-government yields to stay on a tightening path as issuers have now dealt with a large portion of their borrowing requirement while banks’ high-quality liquid asset requirements are likely to ramp up – and with them demand for semi-government bonds.

On the other hand, an expected massive increase in Australian dollar government and semi-government issuance may also be opening the door for investors to see value in supranational, sovereign and agency (SSA) issuance. Australian dollar SSA volume in 2020 pales in comparison with government and semi-government syndicated deals. However, Langer says recent mid-curve deals have been relatively attractive in the secondary market.

Limited SSA supply may continue to support the sector’s relative value in Australian dollars. Kirkham tells KangaNews the recent performance of semi-government spreads, and the tightening of bank spreads on the back of limited issuance expectations, has made SSAs a valuable alternative.

At the same time, credit-market conditions also significantly improved during Q2. Sonia Baillie, head of credit at AMP Capital in Sydney, says the weight of supply from the high-grade sector provides an impetus to weight toward rates, but the technical factors supporting credit spreads make financials and some corporates an attractive option too.

Primary credit deal flow was slower to return to Australia than Europe and the US, where central banks took an active role in markets by buying financial-institution and corporate bonds. However, by late June there had been a flurry of Australian dollar action from overseas and domestic financial institutions and even a handful of corporate deals, including one from Brisbane Airport Corporation, that showed the market’s ability to see through the crisis to greener pastures.

However, investors have little expectation that corporate deal flow in H2 will make up for the expected absence of the market’s largest credit issuers, the big four banks, from wholesale issuance in the near term at least.

“We do not anticipate major banks or many corporates needing to come to the Australian dollar market, meaning there is technical support for spreads despite the uncertain outlook. Investment-grade corporates are attractive and we think downgrade risk is reflected in spread. We think it makes sense at the moment to add credit,” Baillie explains.

“The commitment and capacity of the RBA and other central banks has been put beyond all doubt for now, which suggests market sentiment can remain elevated relative to fundamentals for a long time yet.”

Faith in the system

Fund managers appear to have a good degree of trust in the RBA’s promise to help maintain market function and liquidity. Record high-grade issuance volume has been absorbed since April, despite the economic hit from COVID-19 still looming especially as government stimulus measures are due to expire at the end of Q3.

The Australian economy had largely reopened by the end of H1 but, at the same time, economic data for growth and unemployment have begun to reflect the grim reality of COVID-19 lockdown measures. The income hit many consumers face is potentially only going to be known once the two main planks of government stimulus – JobSeeker and JobKeeper – are unwound. Meanwhile, in early July a spike in COVID-19 infections in Melbourne spurred a second city-wide lockdown.

Markets appear unsure about the likely course of action – or at least different asset classes are projecting different outcomes. After a brief period of volatility in March, equity and debt markets have continued the recent-year trend of telling market watchers divergent stories by both rallying at the same time.

“Market sentiment has been dislocated from reality for many years now. The recent market moves are merely another chapter in the book. But the commitment and capacity of the RBA and other central banks has been put beyond all doubt for now, which suggests market sentiment can remain elevated relative to fundamentals for a long time yet,” Hamlyn tells KangaNews.

Investors say they are not ignoring the obvious risks on the horizon. However, faith in central banks’ commitment to being the buyer of last resort is currently sufficient to assuage any doubts around borrowers’ ability to repay debt.

Hamlyn continues: “It is an unusual situation where there is an enormous increase in debt issuance and a very weak outlook for the economy and tax collection, but at the same time government bond yields are at all-time lows. This indicates very little doubt about the ability of governments to service even an elevated level of debt. At the end of the day, the ability to repay debt is the essence of fixed income and at the moment there does not appear to be any concern.”

Australian investors also have the sense that, even though a lot of the economic pain is still to come, there was at least some clarity on the outlook by the end of the first half and fewer unknowns than was the case in March.

“Issuance has been consistent and it has all been swallowed by investors. Borrowers are issuing into demand, which means there is limited scope for a blowout in high-grade or credit spreads.”

Baillie tells KangaNews the sharp spread revision in March factored in a lot of downside risk as well as liquidity premia. Furthermore, she says rating agencies have been quick to respond, meaning deteriorating credit profiles are also largely factored into pricing.

“There is of course still a lot of uncertainty around the risk of a second wave of COVID-19 and the need potentially to go back into lockdown. But the second ride on the ghost train is not as scary as the first. A lot of measures to support the market are now in place so, while there could be pockets of volatility, the outcome is unlikely to be as severe as it was in March,” Baillie says.

Economic outlook

A ghost train may end up being an apt analogy for the Commonwealth and state economies in the wake of COVID-19. Massive increases in government spending with the potential support of central-bank purchases have proven effective in putting a floor under economic growth in the short term. But a major question mark remains over the prospects for a long-term growth recovery driven by private-sector investment and productivity gains.

The various QE programmes implemented around the world in the wake of the 2008 financial crisis have proved difficult to unwind. This point may be some way off for global central banks, but if it does happen the Australian market could be exposed due to its emphasis on supporting front-end yields.

Hamlyn explains: “By providing explicit support for short-end bonds and more discretionary support for long-end bonds, the RBA is effectively borrowing the capacity of other central banks that are willing buyers across the yield curve. This approach works well when central banks are delivering maximum stimulus, but when this support is unwound support for the Australian market will be unwound too.”

“If it was just Australia at risk of downgrade it would be an issue. But at the moment all countries are in the same boat and, relatively, Australia is in a better position than many. Australia’s level of debt is still going to be magnitudes lower than most other developed economies.”

The Australian implementation of unconventional monetary policy has so far been very different from other jurisdictions. In particular, the RBA has only had to buy a relatively small volume of bonds to facilitate lower yields and successful issuance by federal and state government entities.

Between late March and early May, the AOFM issued A$36.1 billion of ACGBs by tender or syndication. In the same period the RBA took a little more than A$40 billion off investors’ books. Since early May the AOFM has been able to issue A$50.5 billion of ACGBs without the RBA purchasing any bonds in the secondary market.

This pace of issuance is set to continue for the near term at least, and semi-government requirements will likely be elevated for some time to come as well. The RBA’s explicit messaging around its intention to intervene to whatever degree is necessary for as long as is necessary has put investor concerns around a supply deluge at ease, though.

“Issuance has been consistent and it has all been swallowed by investors. Borrowers are issuing into demand, which means there is limited scope for a blowout in high-grade or credit spreads,” Kirkham argues.

The rise in issuance is also being facilitated by a return of liquidity to local asset managers. Investors universally report a stabilisation in the drawdowns that occurred during March (see box).

There has also been a notable increase in global investor demand for Australian dollar high-grade product, says Hamlyn. This has occurred due to other central banks intervening more in their government bond markets than the RBA has, leading to Australian dollar yield becoming attractive compared with global options.

“Rising supply has been well met by demand so far, so we continue to see opportunities in holding government bonds. A large ramp up in supply would, in isolation, be a cause for concern for investors. But it is not occurring in a vacuum,” Hamlyn explains.

In fact, the increase in debt issuance from the Australian federal and state governments may actually be beneficial for ratings in the long term, if the economic support provides a sufficient boost to offset the long-term debt burden. Australia’s relative position remains strong, too, despite the rapid weakening of the budget and fiscal position.

Langer explains: “If it was just Australia at risk of downgrade it would be an issue. But at the moment all countries are in the same boat and, relatively, Australia is in a better position than many. Australia’s level of debt is still going to be magnitudes lower than most other developed economies.”

Liquidity from all angles

At the peak of financial-markets turbulence in March, liquidity across the spectrum of risk assets evaporated. Fund managers say the Reserve Bank of Australia’s measures have largely reversed this and liquidity has returned in primary and secondary markets as well as in client flows.

Liquidity problems began in March and snowballed when the federal government announced plans to allow early access to superannuation, leading to large redemption calls on domestic fund managers. However, by late June fund managers say these issues have largely played out and even reversed.

Investors say secondary-market liquidity has greatly improved from March, to the point where they can execute typical sector rotations between semi-government and supranational, sovereign and agency (SSA) bonds.

Darren Langer, senior portfolio manager at Nikko Asset Management, says liquidity is only part of the contemporary equation, however. He explains that investors and banks are driving spreads in quickly, but not evenly. Volatility between sectors is higher than usual and this creates switching opportunities.

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