JAMPALA For fixed-income market participants, and global macro in general, the coming few years would appear as exciting as any we’ve had since the turn of the century. With diminishing monetary policy intervention, unconstrained markets augur for a fascinating marketplace.

When it comes to spread product, and views thereof, there are many different things pulling in different directions. On a relative-value basis, credit is cheap versus equity. Conversely, one can make an argument that credit, given the outright level of rates, is technically quite tight. On the other hand, the outright level of rates is, relative to recent history, very attractive.

It is a real push-pull, whereby the universe of credit and fixed income more broadly offers many opportunities on an outright level and from a relative-value perspective. There is something in it for everyone.

BARRINGTON We have seen a change in the composition of investors participating in the Australian fixed-income market over the last two years – it is diversifying. Historically, the bank market, for instance, was dominated by FRN [floating-rate note] buyers heavily focused in the CLF [committed liquidity facility] space. However, as outright yields have risen, we have seen the expansion of fixed-rate buyers from Australia and offshore.

The main development is the number of investors. We see this in offshore participation in particular: there is more of it in the primary and secondary markets, and in sectors from semi-governments to the local credit market.

Going back a couple of years, when spreads were a lot tighter in general, to get better return investors either had to give up liquidity, credit quality or duration. Now we have moved to an environment where liquidity and spread are both available.

Having said this, we still find that there is a lot of focus on the major-bank curve and the size of their trades, because investors are seeking the most liquid points. In fact, to some extent we are seeing even more investors in major banks because they no longer have to move down the credit curve – and thus give up liquidity – to get yield.

KULUPPUARACHCHI It is the same with duration, and it starts in the US. There is a lot of demand across US investment-grade credit in the two- and three-year part of the curve, and this is replicated in Australian banks’ US dollar issuance. Investors have had an opportunity to get great yield and to do so with just two or three years of term.

This type of demand has really helped the Australian banks’ first wave of TFF [term funding facility] refinancing. Another example has been Australian banks’ ability to issue short-to-mid curve covered bonds in the European market. This has also aided ‘TFF 1’.

I agree, also, that the Asian investor base is growing – this is a significant development. We have known that this group has been growing for many years since the global financial crisis, but we have now got to a stage where our biggest customers are a combination of domestic and Asian accounts. The size of investors in the region is growing just as much as our local super funds are growing.

To add to this, JACI [the J.P. Morgan Asia Credit Index] and JACI II – though the latter is yet to be adopted – is spurring another avenue of buying, from a client base that needs to acquire Australian credit bonds because it is tracking the index.
This is likely to really help the next wave of TFF redemptions, next year, as each bank name will have a certain allocation in the index and will benefit from the increase in demand for Australian banks denominated in US dollars.

On the other hand, Bank of Japan (BOJ) yield curve control (YCC) changes will likely decrease Australian dollar credit demand so the addition of Australian credit to JACI plus the growing presence of Asian and ETF [exchange-traded funds] buyers will be vital.

GIFFORD It is really wonderful that we are all discussing increased depth in the Australian dollar market. From the issuer side, we continue to be positively engaged with the domestic investor base. These accounts continue to give us feedback that they retain very strong appetite for further supply.

At the same time, it is important to reflect that the TFF was used to repay a lot of bonds – which means our outstandings have still not got back to where we were before the TFF, even though there have been these large transactions of A$5 billion or more. Our strong sense is that there remains a high level of unmet capacity in Australian dollars.

We continue to be told by investors that the themes that came up at the start of this conversation – that there is some real term premium available, rates look attractive and bonds are generally appealing – add up to an environment in which asset allocators for Australian real-money and superannuation funds are having a much closer look at bonds as an asset class.

I think it’s fair to say that some of us have been expecting Australian dollar deal volumes might fall. Maybe this will happen in time – but equally we might continue to be surprised on the upside in the Australian dollar market for a period of time yet.

BAILLIE We are always considering the technical factors that can move spreads around from a relative-value perspective. Credit spreads haven’t really traded on the fundamentals for a long time; the market has been flow-driven, with valuation reflecting the demand-supply dynamic.

As a super fund, we are more buy-and-hold investors rather than seeking to trade, for instance, bank paper. We try to take advantage of liquidity premium when it emerges, which means we can be a counterbalance to mainstream trading dynamics when there is high volatility. The challenge, as our sector continues to grow, is to stay invested – to continue to put steady inflows into play.

CUNNINGHAM We do not have a lot of demand for bank paper. Our cash portfolio, for example, is predominantly invested in assets like term deposits and negotiable certificates of deposit. We have capacity to hold some FRNs but they need to be shorter duration and of good quality. Going back two years, for example, there were not a lot of major bank FRNs in there because these securities just were not giving us enough yield. The cash portfolio needs to be high quality and highly liquid.

We keep credit separate from our fixed-interest allocation, and our fixed interest is all government bonds – we don’t have any bank paper or credit in there, either. From a credit perspective, bank paper doesn’t really meet our return hurdle. Our fixed-interest portfolios are managed passively to an index. They have some semi-governments but we don’t buy them directly.

Ultimately, this setup comes down to our view on why we have fixed interest in our portfolio in the first place. The sector is designed to be defensive and highly liquid.

SCHILLER QTC [Queensland Treasury Corporation] offers its clients a fund to invest surplus cash, with bank paper held as a liquid asset. The 2022 financial year saw credit spreads widen as the major banks returned to funding following the end of the TFF. Following this, credit spreads have been range bound over financial year 2023. Even so, there have been great opportunities to invest at attractive levels in three- and five-year major-bank FRNs.  

With the depth in the Australian market over the last year, a key focus for us has been on investment in Australian ADIs [authorised deposit-taking institutions] rather than offshore jurisdictions. This was also in preparation for issues we saw arising offshore due to the tightening of financial conditions globally.

Current conditions have been favourable for issuers as credit spreads are trading toward the tight end of their range over the last year.

On the asset management side, we are focusing on where to invest along the credit curve. Our investment strategy is also consistent with how we think credit spreads will move in 2024. Specifically, we are concerned about a material increase in risks in 2024 as higher interest rates start to have an impact on economies around the world.

This is not to mention the US election, which could also be a source of volatility. Still, these prospects mean that the next few years will be very exciting for fixed-income market participants.

CORBETT Liquidity has certainly increased over the last period – dramatically so. It is not likely that the audience is much broader, though. Rather, we have larger investments coming from particular sectors of the market – bank balance sheets, in particular, on the back of HQLA [high-quality liquid asset] needs.

It has been a fortunate trade-off: the state governments as a whole have needed more money at the same time as banks need more HQLAs. The associated swap activity, and everything that comes with it, has been a sure driver of swap spread in Australia – such as sixes and threes and the long end.

BARRINGTON It is certainly true that a large part of the turnover story has been driven by the existing domestic investor base – primarily the balance sheets. But we have also witnessed an increase in offshore buyers attracted to higher outright yields. This increase in turnover, liquidity and investor diversity is creating relative-value opportunities across the whole semi-government sector. As a result, we are seeing more investors – predominantly domestic – focused on relative-value trading strategies, which is further adding to turnover and liquidity.

Offshore buyers coming in at any specific point in the curve creates opportunities for domestic funds to do more relative-value trading. Increased turnover means they can put on trades, whereas in the past the value may have been there but executing in the size needed was difficult. I suspect real-money accounts domestically would discuss their increase in activity as the product of relative-value trading.

BAILLIE This ties back to the theme we keep alluding to, in other words the attractiveness of fixed income and how it has changed from, say, a decade ago. I believe the difference is that there is more space for active strategies now than there was in the past.

For instance, there is higher volatility now as a result of the slightly different policy paths central banks are taking. This creates more relative-value opportunities, whether they be in sovereign, semi-government or credit bonds. The environment we are in – including the uncertain outlook around inflation and growth – means all these strategies will be more compelling.

JAMPALA I should start with a mea culpa: I have been calling Japanese rate normalisation regularly for quite some time. I was bound to be right at some point! Now we are here, it is very easy to say it is just another development and that the market has absorbed it.

But any student of financial markets history should recognise how significant an event this is. We have had a complete absence of term premia for the best part of two decades and a huge factor has been Japan. It has suppressed global yields for all this time.

QE as we know it is now being unwound, to some extent or completely, in many jurisdictions. I think we have largely seen the end of QE: the world now recognises that it comes with significant costs, not least of which is the extraordinary widening of wealth disparity.

As well as this pressure, we are also experiencing repricing of the yield curve – and this is being led by Japan. The 10-year Japanese government bond yield reaching 0.6 per cent doesn’t mean so much, but it could well exceed 1 per cent in the next few months – and this changes the landscape for global duration.

This is not a bad thing – it will just necessitate a repricing of duration, whereby we go back to where we were before the pandemic and the financial crisis, and almost before the Bernanke-to-Yellen Federal Reserve axis, where we had genuine term premia.

In the short term, there will be price ructions as BOJ normalisation takes place – and there will be liquidity gaps. But in the medium term we will get back the halcyon bond markets of the 1980s: real markets and the absence of overwhelming central bank influence. This is really exciting.

CORBETT The BOJ decision, or the first tweak of what could be a larger, longer-term decision, will certainly have impacts on the market. One of the key considerations for us is that Japan owns a very large portion of Australian high-grade fixed-income product – and a decent portion of that is semi-government paper.

We are yet to witness any movement from Japanese investors. However, we need to be thinking about it in the next 3-12 months. If there is a step back in buying from HQLA accounts simultaneous with Japanese investors buying less or, worse still, starting to liquidate, we could see a reasonable disruption in pricing and liquidity.

I do not expect a market failure outcome but rather a necessary repricing to reflect the change in equilibrium. A significant widening would be necessary for customers to engage once again.

BAILLIE I agree that what the BOJ does from here will be critical. I will actually be watching the relative-value trades, and perhaps more so in spread product. This is the shoe that is more likely to drop first – rather than semis or sovereigns.

KULUPPUARACHCHI We are starting to see the impact of the BOJ’s YCC action in the SSA sector and expect this to affect semis as well. Duration assets are vulnerable to the BOJ’s YCC policy.

We are already starting to see Japanese clients elicit their concerns about hedging costs between US and Australian dollars, with Japanese investors saying they would like to move to a more domestic bias. If this trend were to increase, we would see material selling of SSA product.

This would put a greater burden on central banks and sovereign wealth funds, which are currently the largest buyers of SSAs, to pick up the buying slack. The domestic investor base is not actively buying SSA bonds as the preference for HQLAs remains among this investor base.

It must also be noted that SSAs trade in larger blocks. As dealer inventory decreases and funding costs rise, this will put greater pressure on secondary market liquidity. SSA liquidity is coming under further pressure as, unlike higher beta credit, this market has not seen growth in its investor base.

The BOJ situation also creates a hedging issue for SSAs as the natural mechanism has been to EFP swap hedge. Swap hedging will be very difficult in an environment where Japan is going to be receiving as well. This could lead to an ineffective hedge.

CORBETT The swap spread complex has been a significant talking point of late and we have seen heightened activity across the board. The BOJ and the prospects of QT in Australia have led to the market getting quite excited about swap spreads being materially narrower.

We have seen a lot of business to this effect over the past month or two. I would put the ratio of customers that are anticipating QT versus not at 70-30 on our ledger, and their risk commitment broadly matches this sentiment. While this makes fundamental sense, we need to be mindful of a material repricing higher in yields and credit widening that could take place.

If a lot of semi-government stock starts to come back from offshore, asset books will have to put some form of swap hedge in place leading to a base or, if extreme, some sort of second order re-widening.

Post BOJ announcement, we have seen a reasonable move narrower in spreads. However, global macro outright paying and the steady asset swapping of HQLA assets has prevented a free fall.

CORBETT Their view, collectively, is that there will be some kind of symmetry around the payoffs. A lot of this is predicated on the fact that we are approaching the end of the cycle.

The view tends to be that if the RBA comes out tomorrow and definitively says there will be no QT, spreads would only widen by 4-5 basis points. Conversely, if we are going down the QT path, they think it would mean a 15-20-point narrowing. I personally don’t agree with these metrics, but it is very much what our customer base is saying.

SCHILLER Negative term premia in 10-year bonds presented the opportunity to lengthen liability profiles over the last few years. The term premium is now returning to yield curves as central banks become a less dominant source of demand and as uncertainty over the path for real rates and inflation lessens.

This presents great opportunities in bond markets moving forward, as financial conditions continue to tighten and central banks reduce the size of their balance sheets.

We currently have a relatively neutral view on swap spreads with the 10-year breaking below 40 basis points. Strong domestic receiving has coincided with offshore paying. There is the potential for swap spreads to tighten further subject to the RBA announcing quantitative tightening.

SCHILLER Our thesis is indeed a re-steepening of yield curves, especially as we approach the end of this period of monetary policy tightening globally by central banks, in 2024. Part of this view of steepening yield curves also relates to whether the US economy will achieve a soft landing. There are mixed signals emerging globally. However, certain leading indicators remain concerning and a meaningful recession in the US next year can’t be ruled out.

BAILLIE A shifting of rates volatility from the short to the long end is the main theme. We can debate the level of term premia but the starting point is that the US curve is inverted and term premia are back. This is probably going to be where the market is more focused, in light of what is happening in Japan.

KULUPPUARACHCHI The impact the BOJ could have on the back end of the US investment-grade curve should not be underestimated. The main buyers of back-end long bonds are insurance funds in the US, followed by Japanese, Taiwanese and Korean accounts. If Japanese investors decide to look locally for assets and the demand for US long bonds dissipates, we could see steepening of credit curves.

At present, 30-year US investment-grade long bonds serve a very important part of corporate issuance and the functioning of healthy credit markets. While US insurance investors could meet some of the demand, Japan has been a critical component of deal-making in the back end of credit curves.

We can see already see this repricing, but credit spreads will probably widen further – it is one of the dangers of this set of circumstances. The crescendo effect of pressure on corporate long-bond issuance will lead to wider credit spreads in the front end and belly of corporate curves.

If Crispian’s view on the US economy plays out – that it may experience more of a bumpy ride than a soft landing – we may see a mix of buyers and sellers with outright rates and spread moves. This will make for a fascinating time in credit markets.

GIFFORD The debate we have been having here is certainly live among global investors. At the start of the year, we priced the first Australian dollar 15 non-call 10 (15NC10) tier-two deal and we were pleasantly surprised by the orderbook for what was a A$2 billion transaction: about 60 investors took part.

Since then, we have really seen a firming of the 15NC10 asset class in Australian dollars. As well as peer issuance, we are experiencing strong reverse enquiry from domestic investors that would love to see further supply in 15NC10 format. To answer your question, there is currently significant appetite for duration among a subset of investors.

Meanwhile, another group of investors retains a preference to stay short; perhaps they have a view that rates have a little further to rise. This has seen very strong demand in the 2-5 year part of the curve.

Overall, there is plenty of interest in the tenor we want: as an issuer, 3-5 years fits our balance sheet really well for senior debt and the 5-10 year part of the curve for tier-two.

KULUPPUARACHCHI The investor base wants issuance around the two- and three-year points in the US and Australia. On the flip side, corporate borrowers want to get duration – and demand is emerging at the longer end. Domestically, this is particularly in the 7-10 year maturity space where, on an asset-swap basis, spreads are starting to look more attractive.

We are starting to see some buying of corporate bonds, even in the more challenged REIT sector, around 2029-31 maturity. One of the best deals in Australia in recent times was the AusNet Services 2033 maturity, which priced in May. This deal highlighted how, with a robust domestic and offshore book, high-quality names can still print deals with duration that works for everyone.

All in all, I think there is appetite for long tenor but it is not of the scale we experienced in 2016-18, when issuers like Santos and Pacific National were able to bring successful 10-year deals without US investor presence. The scale of appetite is still not there and what demand is in evidence is very much on a deal-by-deal basis. To be fair, a lot of triple-B Australian corporates don’t require funding to the same extent as offshore peers due to their balance sheet sizes.

The trend in the US investment-grade markets is to print at the front end, where the investors want supply. Everyone is more or less happy to print there.

I’m interested to see whether we can develop traction in 10-year tier-two bullets – I would love to see this being tested locally. Perhaps not right now, because we are still dealing with banking crises and financial issues. But issuers like BNP Paribas have been able to come to the additional tier-one (AT1) market recently – there is appetite that appears to be growing.

As equity markets have been stable and volatility has eased, it may be time to start to think about the duration play – and, if there is a bear-bull steepening, to consider real credit value on an asset swap, instead of an outright, basis. Overall, though, we are not near to the same settings as we were before COVID-19 and QE might be a thing of the past.

GIFFORD With regard to tier-two bullets, the other factor is balance sheet needs. Ourselves and our peers have made really strong progress in our tier-two issuance tasks. TLAC [total loss-absorbing capacity] can also be met by excess CET1 [common equity tier-one] and AT1, which has helped most of the Australian banks be well progressed with their tasks.

We did a US dollar 10-year bullet tier-two deal in November last year, in a pretty tricky market. When we were on roadshow through the US we made the point to investors that we see the 10-year bullet as a very defensive product that we keep for difficult markets.

We know the US dollar tier-two market is incredibly deep, particularly with regard to 10-year bullets. With more constructive markets at the moment, we would tend to favour issuing callable structures rather than bullets as from our perspective they are more efficient economically.

GIFFORD It is also worth noting a couple of important points supporting recent Australian dollar supply. US dollar spreads remain elevated following recent US regional bank concerns including the failure of Silicon Valley Bank. Combined with the deepening support of the domestic market in Australian dollars, this has led to a shift in the supply and demand outlook for US dollars. However, I expect, in the long term, that some of these dynamics will revert to historic norms and therefore a US dollar funding revival.

In the TLAC accumulation phase, it wasn’t uncommon for the major banks each to do two US dollar tier-two benchmarks a year. Between the four of us, US investors would not have to wait too long for a new deal – there was always another primary opportunity coming so there was no need to chase in the secondary market.

We are very open with US investors that the dynamic has shifted recently and the TLAC build is well progressed. We had a 5.5 per cent tier-two ratio in March and our peers are similar. Our guidance now is that investors can expect to see ANZ issue once a year in US dollar tier-two format, so the supply-demand picture in US dollar tier-two is much more balanced nowadays.

GIFFORD I would describe the stance of our funding team as ‘proactive’ over the past 12 months: we have certainly aimed to stay ahead of the run rate. For example, our previous annual guidance was of a A$30 billion wholesale funding task and yet we had done A$25 billion at the half year. This clearly demonstrates our strategy of remaining proactive in uncertain market conditions.

There is now a lot of dialogue around where the world is going and the likelihood of a US recession. Many of us are positioned for this, though. What surprises me has been the resilience of the consumer and how resilient economies are globally, given how high central banks have gone.

We are giving more time internally to interrogating this thesis, aiming to form views on what happens in the world if rates are higher for longer, credit growth slows and deposits increase.

One possible situation is that banks globally pre-funded a lot, QT is slower than expected and Europe, for instance, loses roughly US$50 billion in deposits each month – not a great deal, in other words. This would start painting a picture in which banks could get over-funded, with issuance surprising on the downside and credit spreads contracting.

This is not our base case but we are starting to interrogate it more, and our stance might perhaps move from being overtly pre-funding to just exploring whether any given deal opportunity is the right thing to do at the time. The major banks constantly need to fund, so we can’t ever get too far behind. But it is a question of how far ahead we need to be.

SCHILLER Incoming data on the US economy points to fading momentum, but many indicators – especially those related to the labour market – have held up reasonably well. This is sending mixed signals and, when combined with the moderation in inflation, is leading to more discussion about a soft landing.

However, we are not convinced – we believe a recession is more likely than not. Stresses being felt by US households with the cost-of-living crisis and in the US banking sector with rising interest rates reveal some latent vulnerabilities.

Sticking with the US, the macro outlook remains very uncertain but we will continue to look at opportunities as banks require funding. We expect credit spread ranges from the last 12 months to hold, with three-year major-bank paper trading at 70-90 basis points over swap and five years trading at 90-110 basis points over swap. Equity markets look fully priced for a soft landing, though – such that a correction in equities may push credit spreads back to the wider end of these ranges.

SCHILLER We have shortened the tenor of our investments outside the major banks. The focus has been on investing less than 18 months for non-major domestic ADIs [authorised deposit-taking institutions] given the shape of the credit curve.

The push higher in the six-month BBSW rate through July as the banks manage upcoming maturities of the TFF also presented an opportunity to invest shorter without giving up return. ADIs are currently very well capitalised, which may reduce supply over the coming months.

BAILLIE Each super fund is a bit different because of its member composition. Our member base tends to be a little younger: the average member is about 45 and the majority of our members sit in the growth or high growth options. Our overall asset allocation is 90 per cent growth assets and 10 per cent defensive.

I agree that stepping back and looking at the relativities of asset classes is important, but the strategic asset allocation is pretty much set. While it is worthwhile to think about how we might use the duration or credit levers within sectors, there is not going to be a significant shift at fund level because of the product design.

CUNNINGHAM Fixed interest plays a defensive role in our investment options as well as forming part of our liquidity. The latter point is an important one to remember in relation to Australian super fund investors: we are in a defined contribution world, not a defined benefit one.

Our members can switch between options, such as from our high growth or growth option to cash, with very short notice. Members also have the ability to move between different superannuation funds, again with very short notice.

Liquidity is really important, and it is not just at the fund level but across the options we manage. We try to make our fixed interest work harder for us, through things like our security lending programme.

CUNNINGHAM Super funds are getting more sophisticated. Many are taking DAA [dynamic asset allocation] decisions. For instance, views can be expressed using various derivatives and options that kick in from time to time to take advantage of particular positions. We have internal asset allocation, and capital markets and execution teams with the capabilities to do this.

BAILLIE Many super funds’ fixed-income and credit-return objectives aren’t necessarily the same as the APRA [Australian Prudential Regulation Authority] benchmarks. There is a dual awareness of performance objectives for sectors and funds, and where Your Future, Your Super benchmarking comes in depending on asset allocation. A lot of super funds have tended to shift, over time, from fixed income to cash and credit.

There is also a general level of tracking error regarding duration exposure. This is going to be more relevant in the period we are in now.

The return objective for our credit income sector is bank bills plus 300 basis points, which will be built from a combination of external managers and our internally managed portfolio. This is all floating rate, yet the benchmark we will be measured against for Your Future, Your Super is fixed. This is something we have to monitor and manage.

CUNNINGHAM Our credit sector has a floating-rate objective with an appropriate spread required over bank bills. It has a liquidity requirement as well, which we generally access in offshore markets. If we buy a corporate bond in Australia there is often limited ability to sell it – it might take 10 days even when conditions are good.

We are very conscious of these kinds of things. When we buy something we generally assume we are going to hold it to maturity. We are actually exploring becoming a little more active with our direct investing in the bond market, but we are still conscious of the market we are buying in.

In the past 12 months, US high-yield spreads have come in to 390 basis points from 570. This compression has delivered good performance across our credit sector.

The other benefit of being a floating-rate investor is a higher base rate. We have a lot more to protect us from spread widening or from defaults, which is something we didn’t have when base rates were zero.