In recent weeks, several global central banks have initiated long-awaited easing cycles. The Bank of Canada took the lead by cutting interest rates, followed closely by the European Central Bank, which slashed rates for the first time in almost five years. Meanwhile, the US Federal Reserve has opted to maintain its current interest rate stance.
Closer to home, the Reserve Bank of Australia (RBA), which will next meet on 17–18 June, appears to be a long way away from rate cuts.
Schroders sees interest rate opportunities as varying by country, suggesting that this perspective can unlock attractive opportunities even within the Australian market.
Presently, the RBA faces the difficult last mile to bring inflation back to target, which poses an interesting case for fixed income investors, according to Schroders’ head of fixed income, Kellie Wood.
Australia continues to grapple with stubborn inflation, as reflected in May’s CPI data, which surpassed market forecasts at 3.6 per cent year-on-year, according to the Australian Bureau of Statistics (ABS).
Additionally, ABS figures for June revealed that GDP growth in the March quarter hit a three-decade low, with a mere 0.1 per cent increase and a 1.1 per cent rise since March 2023 (seasonally adjusted, chain volume measure).
“The current level of interest rates is clearly restrictive, with Australia one of the most rate-sensitive economies, with high levels of floating rate mortgage debt. However, services inflation remains too high, and if progress on goods inflation has stalled, the RBA may be forced to implement another ‘insurance’ hike as they contemplated in their last meeting,” Wood said.
“A further rate hike may just be the tipping point for the mortgage sector. The corporate sector thus far has been coping with higher rates, with pricing power enabling them to maintain margins. However, cracks are starting to appear and the equity market is getting prepared for disappointment on earnings.”
She emphasised credit opportunities, noting a “significant dispersion” that presents an “excellent” opportunity for allocators. Namely, spreads in European and Australian investment-grade (IG) and subordinated debt were highlighted as offering better value compared to expensive US IG and high yield.
“Australian IG is higher quality and provides better inflation resilience through its sectoral exposure (high weightings to infrastructure, utilities and transport names with CPI-linked revenues). Australian subordinated bank debt also stands out as attractive, with increased issuance to meet higher regulatory capital requirements seeing Tier 2, in particular, trade cheap relative to both higher-ranked senior debt and lower-ranked hybrids,” she elaborated.
Additionally, Wood outlined opportunities to diversify beyond corporate credit into mortgages and securitised assets, both in Australia and the US.
“The interest rate cycle and Fed balance sheet reduction are keeping US mortgages cheap relative to corporates, despite a yield and rating uplift,” she explained.
“In Australia, the value proposition is similar with pre-pandemic residential mortgage-backed securities (RMBS) vintages on attractive loan-to-valuation metrics and weighted-average life below two years still yielding 90 bps over bank bills.”
Chris Siniakov, managing director at Franklin Templeton, believes that part of the credit opportunity arises from the fact that these markets have been “functioning beautifully”.
“Right now, and for the last couple of quarters, credit markets have been functioning beautifully. We have had a lot of issuance from companies around the world, especially in investment grade credit, and that’s been digested or absorbed by global markets with great ease,” he said.
“Typically, what happens is when a company or entity comes to the market with a new bond, they do it at a bit of a concession to the existing bonds in the market to get the deal away. They might put in an extra 10 or 20 basis points over their existing secondary market. Well, the demand has been so strong that a lot of new deals have been oversubscribed by four times. The functioning of the market has been really strong.”
However, he cautioned that the era of easy money has ended, compelling fixed income investors to adopt a more innovative approach.
“Credit spreads have contracted, so in 2022, when we had the real big interest rate increases around the world, the uncertainty of the impact of those increases on economies repriced credit wider in spreads, and it subsequently contracted.
“If you look at 12 or 18 months in credit, they’re stellar, but I think the kind of easy money to be made is done, and so, from here, spreads are at or close to their long-term lows, and we should think about the carry being the main contributor of return, rather than capital gains from credit,” Siniakov said.
Unpacking the firm’s own approach to a year of stubborn inflation and low growth, he highlighted the importance of discerning between different levels of risk.
As the co-portfolio manager of the Franklin Australian Absolute Return Bond Fund, Siniakov said he currently prefers high-quality and shorter-dated securities.
“In Australia, where we’re going into very subdued levels of growth, maybe even a technical recession in coming quarters; in the US, where it’s elevated but everyone predicts it’ll have a lower growth rate by the end of this year and going into next year – as you’re going into that deteriorating economic environment, make sure you understand the entities you’re lending to and how they might navigate through a more challenging environment,” he said.
