Strategic focus shifts in Australian dollar credit investment
Yield is increasing as global central banks attempt to control inflation. This is leading credit investment strategy to shift – notably targeting shorter duration and demanding stronger credit profiles. Aidan Shevlin, head of international liquidity fund management, and Theo Hadiwidjaja, credit analyst, at J.P. Morgan Asset Management in Hong Kong, discuss the Australian credit market in this context.
What is your outlook for Australian dollar credit?
SHEVLIN The market is pricing in three or four rate hikes this year, even though the RBA [Reserve Bank of Australia] is stressing patience. It is an interesting dichotomy. In this environment, one would expect corporate issuers to try to execute earlier to print their bonds before yield rises.
We have seen government bonds and corporate bonds printing losses in Q1 2022, which is focusing attention on our investment style because investors do not want to be extending duration in a rising rate environment. At the same time, we are seeing corporate spreads widen.
Investors are demanding more of a cushion to make sure they have extra insulation against rate rises. Issuers are interested in executing deals, but at the same time investors are more tentative and cautious.
There seems to be buy-side concern about spreads widening further over the next 12-18 months. Will this make asset managers more strategic in their behaviour?
SHEVLIN The trend is definitely toward the shorter end of the curve. If we look at what has been printed so far this year, we have seen more interesting prices. This is helpful as we expect BBSW to grind up during the year. By having short duration, the chances of suffering a capital loss are significantly lower even if rates rise, and the ability of the portfolio’s yield to offset capital loss through income over time is higher.
HADIWIDJAJA On the dynamics between the Australian dollar and offshore markets, in December 2021 the government bond curve in Australia had not priced in the potential rate increase compared with the US Treasury curve. This meant Australian pricing was tighter. Right now, it seems that spreads have widened and look more attractive.
The trend is definitely toward the shorter end of the curve. If we look at what has been printed so far this year, we have seen more interesting prices. This is helpful as we expect BBSW to grind up during the year.
There seems to be buy-side concern about spreads widening further over the next 12-18 months. Will this make asset managers more strategic in their behaviour?
SHEVLIN The trend is definitely toward the shorter end of the curve. If we look at what has been printed so far this year, we have seen more interesting prices. This is helpful as we expect BBSW to grind up during the year.
By having short duration, the chances of suffering a capital loss are significantly lower even if rates rise, and the ability of the portfolio’s yield to offset capital loss through income over time is higher.
HADIWIDJAJA On the dynamics between the Australian dollar and offshore markets, in December 2021 the government bond curve in Australia had not priced in the potential rate increase compared with the US Treasury curve. This meant Australian pricing was tighter. Right now, it seems that spreads have widened and look more attractive.
Will this attractiveness persist or be priced out as more deals are executed?
HADIWIDJAJA To a certain extent it will depend on whether investors consider the Australian dollar attractive. The dynamics between rates globally are moving fast. In the Australian dollar market in 2021, close to 30 per cent of participation in Australian dollar credit was from overseas investors. These buyers look at opportunities in US dollars, euros and other currencies.
SHEVLIN Australian dollar credit, companies and financials are a perennial favourite among global investors because of their high credit quality. But this leads investors to consider them as a yield play and to look at them versus the yield they can get elsewhere – in other currencies and similar markets such as Canada or Europe. Australian issuers that operate on the global stage really have to consider their yield versus similar issues around the world, not just their local funding costs.
What will be the main challenges in 2022?
SHEVLIN Expectations for inflation continue to rise and this is painful for entering longer-duration trades. If an investor already has them on they are not ageing well as the market continues to price in more hikes.
There are two key challenges this year. Number one will be to keep duration short. Number two will be when to realise gains by trying to go long again when we think rate increases are fully priced.
Last year was the first time we saw Australian government bonds producing negative returns and already this year we are about 50 per cent negative on last year’s negative result. Figuring out when we are going to see the pivot in the market will be critical.
Are Australian corporates flexible on duration?
HADIWIDJAJA If we go back to December 2021, when the Australian government bond curve had not risen as much as the US curve, it was cheaper to issue in Australian dollars. Spreads were tighter, too.
Presently, the curve has shifted up and priced in the prospect of rate hikes, so it could be cheaper for Australian issuers to fund in US dollars. Just look at Australian banks and how much they have issued in US dollars since the end of the term funding facility. Tenor in the Australian dollar market tends to be shorter than in the US dollar market. Issuers will need to assess cost of funding across different currencies and the tenors they need for their businesses. These dynamics will continue.
