Global market view as rates inflection point looms

DAY Everyone expected central banks to cut rates at some point, but the problem was how much was priced in at the start of the year. Most investors grew up in a world where inflation was always well behaved and central bank rates were 1 or 2 per cent – and that was the expectation as to where we were getting back to.

The problem is that labour markets remain too tight, which means wage levels are too high, which means service inflation is too high as well. This has been a common theme in any services-based economy. It’s a big problem in the UK, it’s starting to get a little better in the US but it’s still far too high, and Australia and New Zealand have the same issues.

It then comes back to the biggest challenge for us: it is rational for central banks to cut rates, but how far can they go? What is a sensible and reasonable level for the terminal rate? The problem is we don’t know. If it’s a soft landing, there will only be a few rate cuts – I’d anticipate two or three at most. But rate markets are already pricing in more than this and, at this level, most markets are too expensive.

On the other hand, terminal rates will be a lot lower if we have a hard landing and unemployment rises materially. This is the challenge we have at the moment. On the back of this, because rate cut expectations are still pretty high – although not as high as they were at the end of last year – we have inverted yield curves in almost every market, except Australia and Japan.

Buying a bond today has quite a lot of hope built in. The hope might be correct, but there is a lot of it. The only way to beat cash by owning a 10-year bond in most markets is for yields to fall. If yields don’t fall much, investors are better off in cash – and in previous rate-cutting cycles yield curves did not remain inverted for so long.

DAY Yes. This year we have gone from no landing to a hard landing, back to no landing and then a soft landing. Markets are oscillating around. One thing we have used a lot more of this year is put and call options, given the uncertainty of rates direction.

FISHER We continue to have a selective preference for Australian dollar credit given our view that it offers better relative value versus offshore markets and also on a historical basis. Australian dollar yields are also proving attractive for Asian investors, which is supportive of the local credit sector.

However, we also think it makes sense to hedge macro risks by purchasing protection on the US CDX IG index. The hedge is currently inexpensive given US credit spreads are much tighter than Australian equivalents and the basis between credit default swaps and cash credit is favorable.

Our preferred way of adding physical credit exposure has been to take part in primary transactions with attractive new-issue concessions.

FISHER We had been discussing the potential for credit spreads to grind tighter over the northern hemisphere summer. However, the snap French election and resulting volatility took the market by surprise, presenting a potential tail risk.

We will be watching the outcome of the election closely as the recent growth in French bank issuance in the Australian domestic market could either further increase the risk of broader spread widening or present an opportunity to add French exposure at more attractive levels.

SMITH Supply from SSAs so far this year comes to just over A$29 billion (US$19.3 billion) – which is up on 2023, also a record year. The Canadian pension funds and provinces have issued in the Kangaroo market before, but not in the benchmark sizes we have seen this year.

The reason for this is a combination of supply-side preference and demand. There has been more demand for duration in the SSA sector more recently – which is a function of the view that Australia might be slower to cut rates than the US, for example. With regard to the Canadian provinces, the stars aligned in supply and demand.

There has also been great demand for the typical, more frequent SSA issuers – so the market has been there for everyone. Q1 saw the bulk of issuance, with A$20.5 billion pricing in the first three months of 2024. As we know, the January sweet spot for SSAs is becoming ever more competitive, with the jostling starting earlier and earlier each year as issuers work to put their flag in the sand.

The market has been a bit quieter over the last month or so. As we get to the end of June and into the new financial year, it will be interesting to see how the Kangaroo market unfolds over the next six months and whether it still stacks up for issuers in relative value versus the US dollar in particular.

DORE We are at the end of our fiscal year. World Bank will end up with US$52 billion of issuance, while International Development Association (IDA) will have issued around US$12 billion.

In the second half of the year, we are aiming to repeat the success we had in the Australian dollar market in the first half. But we need Australian dollar pricing to align versus our US dollar curve. Also, the second half of the year is generally not like the start of the year where investors are expecting a huge amount of supply and have positioned their portfolios accordingly.

We also expect increased volatility into the second half of the year, particularly in some of the developed countries that have major upcoming elections. Australia doesn’t have this issue. However, Australia is not immune: what we typically see is that when there is a lot of volatility in other major global markets, it sometimes results in higher volatility in Australia and, as a result, fewer issuance windows.

GOEBEL We were lucky to be able to capitalise on issuance windows in sterling, Australian dollars and US dollars when they were there. We have done a lot of funding in the 5-7 year space across these three currencies in the year to date. Unlike in previous years, the euro only accounts for 25 per cent of our borrowing task. So far, the US dollar has taken more than 50 per cent while Australian dollars and sterling are at 10 per cent each.

This will change in the course of the year, for two reasons. We are going to seek slightly longer duration than we have raised so far, and this is always readily available in the euro market – we have to pay the credit spread, but there is always demand. Also, we haven’t issued a euro-denominated benchmark transaction yet this year and we plan to issue at least one – and more likely a pair of them – in the second half of the year.

However, after all is said and done our funding this year will not be dominated by euros in the same shape and form as it has been for the past couple of years. Hopefully, there will be more opportunities in currencies away from euros in the second half. 

We have had a fairly good run in the Kangaroo market this year and we hope this will continue. However, with the cross-currency swap market having moved significantly against us of late, it is not in our hands.

SCHOENMAKERS This isn’t an easy question to answer. Every issuer has a different view of how to differentiate between investors. ADB [Asian Development Bank] has an agnostic approach to geography, but we do take the type of investor into account. I think it’s also fair to say that ADB’s books in Australian dollars have not been huge so far. As a result, I don’t think we need to be restrictive in allocations.

As you say, as well, we want our bonds to perform. In this sense, allocations should be a function of the performance we want to get. So far, we have been lucky in that we haven’t been confronted with major issues with regard to allocations.

AINSLEY I think it’s fair to say last year was an exceptional one, in which the demand for Australia was strong because relative value was convincing for many investors. As a result, Australian investor participation in our books increased to 35 per cent, which is much higher than in previous years.
With regard to international investors, Asian bank treasuries played an important role in our trades as well.

Orderbook composition has changed a bit in 2024. In our recent deals, allocations have been 80 per cent to offshore investors with the remainder going to Australian accounts. The move in swap spreads and spreads of SSAs versus semis means we have seen less demand from Australian investors.

This has been countered by a super-strong international investor base – including more central banks engaged in the Australian market. As a result, we have raised substantial volume of Kangaroo bonds – an amount not seen for more than a decade.

This development places the Australian dollar on the radar of more investors worldwide and makes everyone aware that there are good investment opportunities in this market. The expected increase in the rate differential compared with other markets, such as the US and euros, makes the Australian dollar attractive – and it is likely to stay this way.

Everyone expects the RBA to cut rates later than other central banks, and this plays into the hands of investors in Australian dollars. Therefore, I expect demand will continue to be quite strong – mainly from international investors.

DORE The cross-currency basis is making it difficult for US dollar-based issuers like us to access the Kauri market at competitive levels. But we remain hopeful that the basis will reverse course eventually, and we will be able to come back to the New Zealand dollar market.

In 2023, we executed more than NZ$2 billion (US$1.2 billion). We take a long-term view of the Kauri market and have remained the largest issuer of New Zealand dollar bonds outside the New Zealand government, issuing more than NZ$20 billion since our first Kauri bond.

HELLERUP NIB [Nordic Investment Bank] has been in the Kauri market since it started about 17 years ago. Investors know us, and domestic and international accounts have lines allocated to us. Investors are very familiar with what we are doing, which helped this year when there was a super-short window for issuance that we wanted to use. 

We are happy with the trade, which attracted close to 20 investors. This pinpoints that investors will be there when issuers have made the effort to visit them year after year. The domestic allocation was 80-90 per cent and it was dominated by bank treasuries.

SCHOENMAKERS Demand feels positive. We spoke to some local investors around the KangaNews-ANZ conference in Auckland in March, and it was a good-news story from them. The LPR outcome was definitely positive for ADB and other Kauri issuers. As a result, we assume the bank treasury bid will be active.

However, the cross-currency basis remains stubbornly not in our favour, which makes it difficult for a US dollar-based funder to be active in the currency. We are hopeful that one day the cross-currency basis will move again. 

Regarding sovereign issuance, this makes it more difficult to find international investors willing to be meaningfully present in books as they are a little more sensitive to the spread we offer to the sovereign. We are still confident that one day – this year – there will be a fruitful basis and, when this happens, we are confident that bank treasuries will show up to buy our bonds. 

BILL We were early supporters, and continue to be supporters, of the Kauri market. IFC [International Finance Corporation] has issued in the Kauri space in our current July-June financial year, with a deal in December 2023. We launched this trade 30 minutes before the RBNZ’s LPR announcement came out – so arguably it was well timed, but by pure coincidence. 

We wish we could have more frequent visits to the Kauri market as it is important to us. Alongside the Australian dollar, sterling, and Canadian and US dollars, we consider New Zealand dollars to be a major public currency market as opposed to an opportunistic one. 

This fiscal year, we have seen less interest in currencies like Hong Kong dollars and yuan, which were quite strong in 2023. Some of this money has been flowing to Australia and, with the limited investment options in the Asian time zone, we think the Kauri market could also offer a home for some of these funds. 

Perhaps the fact that the RBNZ is somewhat reactive – and maybe a bit behind the curve – could create opportunities in the fixed income market down the road. As an issuer, we would not mind rebalancing the allocations from, say, 80-90 per cent domestic bank balance sheets to more offshore investor participation. The clarification of the LPR also means there is less reluctance from offshore investors to consider New Zealand dollars.

The other thing is the adjustment of local investors to expectations of spread over New Zealand government bonds. For Kauris it used to be, roughly, in the 50s and now it is in the 20s. This shows investors have adjusted to the reality that the sovereign has to a large extent crowded out other issuers.

The feasibility of coming into the New Zealand market is also largely a function of the cross-currency basis becoming more favourable. New Zealand dollar issuance looks more attractive in the seven-year space than in the front end now, so pushing issuance out the curve could be a near-term solution. Nevertheless, issuers will probably have to make compromises in pricing versus other markets.

GOEBEL We were quite upbeat regarding the outcome of the of the LPR because there had been some discussions beforehand about the RBNZ taking an approach similar to what the RBA did in Australia – specifically, not viewing the Kauri market as a liquid option for banks’ liquidity portfolios. Because this did not eventuate, in principle our position as a Kauri issuer has been strengthened.

Unfortunately, the cross-currency basis has been the curve ball of 2024 and we have to see how we can deal with this. I understand other issuers are also eyeing the market, so any opportunity driven by improvements in the cross-currency basis will potentially be short-lived as a number of borrowers will try to capitalise straight away.

What can we do about this? We will continue to maintain our presence with New Zealand investors and visit them once a year – as we did again in 2024. The Kauri market is definitely one where we would be willing to compromise on maturities. 

Typically, we want to get five-year-plus funding for our borrowing. But for the Kauri market, if there was an opportunity, for example, in the three-year space, we would definitely take a look at it just to continue to have a presence in a market that has served us well over a very long period of time.

I remember we were the KangaNews Kauri Issuer of the Year in 2007 – the first time KangaNews gave this award. The market has a very firm place in our attention toward international borrowing markets. We would love to continue to be able to issue there, including if it means going the extra mile. But, quite honestly, we would rather this be by choice of maturity than by compromising too much on pricing.

IRISIK The RBNZ’s recent hawkish pivot appears to have confused the market, likely explaining the tepid demand from offshore investors wary of adding to existing long positions. 

For Nikko, a muted presence in the Kauri market – as well as more broadly in the global fixed-income space – has also been driven by recent notable changes made to the NISA [Nippon individual savings account], the Japanese equivalent of the UK’s ISA [individual savings account]. These changes spurred a shift of capital toward global equities, leaving fixed income unloved.

Given Nikko’s high reliance on a Japanese investor base, the tepid flow into global fixed-income funds in recent years is not entirely surprising, particularly considering the strong performance of global equities.

Additionally, Japanese investors have historically favoured hedged fixed-income strategies. These  strategies are now less attractive due to extremely high hedging costs and the uncertain timing of normalisation following recent interest rate repricing. As Jon mentioned earlier, while interest rate cuts are likely on the horizon, the uneven pace of easing cycles will likely lead to increased volatility.

We are witnessing tentative signs of increased interest in specific segments of foreign fixed income, though. For example, the recent strong performance of the credit market has attracted Japanese investors to high-quality investment-grade bonds, particularly those with longer maturities.

There are also emerging signs of renewed interest in European mortgage-backed securities, particularly in Denmark. This is especially true for investors that have made the strategic decision to allocate to this highly liquid market, which offers attractive yields, in anticipation of an upcoming normalisation of hedging costs. 

IRISIK The New Zealand bond market has been a source of frustration. For some time now, we have held the view that the local economy is cooling rapidly. The labour market shows clear signs of losing momentum and higher interest rates are putting significant pressure on interest-rate-sensitive sectors and household consumption. Per capita consumption is testing lows last seen during the global financial crisis, with consumption expectations also deeply suppressed. 

Despite this, the RBNZ has adopted a somewhat hawkish stance based on recent inflation data. There is persistent nontradable inflation, some of which – such as insurance premia – are clearly beyond the central bank’s control. To us, this raises questions about the forward-looking nature of the RBNZ’s monetary policy and makes it appear more reactive than the fundamentals seem to justify. 

We have held a long-duration position on New Zealand rates for some time and have limited space to extend further. We understand that many market participants are also long duration, which likely explains the muted participation from offshore investors recently.

RUDGARD There is now a real recognition that transition finance is a huge opportunity for investors as it is about all sectors transitioning, including supporting those in hard-to-abate sectors to decarbonise.

On financing structures, we don’t think transition financing should necessarily be restricted to sustainability-linked bonds (SLBs). There are lots of other ways we can support issuers to transition. When we conduct our analysis, it is always at the issuer level. For issuers in hard-to-abate sectors it is more about the credibility of their transition plans, rather than having, or not having, an SLB.

This said, I think the SLB format plays a role in the overall transition finance toolkit. It would be a shame if it completely dies out. But J.P. Morgan’s predictions for labelled bond issuance this year forecast US$950 billion of supply with almost none of it in SLB format. 

Ultimately, we think the focus should be on issuers’ transition plans. This means understanding what is a credible transition plan and what it means in the real world, and how to make a just transition that  accounts for social impacts as well.

RUDGARD This is right. Green bonds have a purpose, but they are limited by their use of proceeds and there is only so much that can be financed via this format. For potential issuers, there is a fine balance between signing up to sustainability targets and being seen as an emitter or being associated with greenwashing.

Prior to COVID-19, there was definitely a view that emitters couldn’t take this path. Since then, however, some emitters have looked to raise funds via sustainability-linked formats. This is forging a path for others in the loans space.

This was a really good example of innovation in the market. Notably, with this transaction the issuer took extensive investor feedback into account especially relating to certain exclusions. It also interacted with Climate Bonds Initiative to get third-party backing. All this combined to make it a very interesting deal for investors.

HELLERUP One of the biggest discussion points is whether issuers can finance transition with a green bond. I agree that there needs to be a plan for transition finance, and also that the SLB has not been picked up as perhaps expected. So far, transition has been financed via loans – and we are considering a product that can finance these transition-linked loans. 

NIB has been in a working group together with Crédit Agricole, J.P. Morgan and the International Loan Market Association, within the Principles managed by ICMA [International Capital Market Association], which has created some guidelines on how to structure bonds to finance transition by packaging up sustainability-linked loans [SLLs]. Nordea has already issued a bond that finances SLLs. With formal guidelines, we will see more of this kind of innovative product.

AINSLEY I think transition can be financed via green bonds. We just updated our green-bond framework including adding our climate protection programme for corporates. This also includes carbon capture and storage, and battery manufacturing, for example. This is in line with the “substantial contribution” criteria of the EU taxonomy.

Transition is important and the update of our framework makes it more international. Until now, we focused only on Germany with regard to the projects being financed. But we are doing a lot of financing across Europe, too. It was only natural to include projects in other countries as well.

It is possible to have transition projects as part of a green-bond framework. It is also important for us as issuers to attract private capital to these kinds of projects, because the transition task is huge.

HELLERUP We are also updating our framework but perhaps we have the opposite view. We have said we don’t want to include transition or hard-to-abate sectors in our green bonds. We will finance these areas as doing so is within our mandate – but we won’t do this as part of our green-bond framework.

DORE The topic of transition finance has generated a lot of interest recently, and rightly so. For countries to transition to a low-carbon economy, transition finance has to be part of the menu of investments. In the case of World Bank, we have a programme for bonds labelled as green bonds. 

Because we have an overall social mandate, all our projects support social and green ambitions – and we take a holistic approach toward transparency by labelling all World Bank bonds that are not issued under the green-bond programme as Sustainable Development Bonds. We have decided not to choose a menu of labels – just green bonds or Sustainable Development Bonds.

But other issuers have taken different approaches, including choosing several labels. Although we have decided not to pursue this path for World Bank, we are supportive of it. At the end of the day, the goal is to finance projects that support the transition to a low-carbon economy and transparency is always welcome.

BILL In the spirit of not adding themes, we have included biodiversity and blue into IFC’s green-bond framework. Our philosophy is to broaden the scope without multiplying themes, which we have also done for our social-bond framework. 

GOEBEL As long as transition is financed at the level of the ICMA Principles, it is supportive for the market. I’m looking forward to the evolution of the ICMA framework with respect to financing transition.

However, from a European perspective, I’m quite concerned about the official regulators. ICMA is also a regulator but it is self-regulated in a very common sense shape and form. I cannot say the same about the official regulation I observe in Europe, where there seems to be an obsession with preventing greenwashing instead of promoting transition financing.

I think this will put some curbs on what we can achieve with any type of labelled bonds. The cost and the legal exposure we incur from the ever-tighter government regulation puts a big question mark on the risk-reward pattern of any type of labelled issuance.

GOEBEL It was clear from the very beginning that our greenbond issuance would not affect our green lending capabilities. The promise made to us was it was still worth developing a green-bond programme because market infrastructure has to be built up and therefore there has to be ongoing dialogue.

But where is the transmission into the private sector? To date, it is largely SSA issuers that have been issuing loads of green bonds. We also buy them from each other for our green-bond portfolios. Is this really going to save a single iota of carbon dioxide emissions around the planet?

RUDGARD This is an interesting point. I would add that the activities we most need to incentivise to transition are the ‘brown’ activities. There is an argument that we could achieve swifter decarbonisation by incentivising the transition of brown activities.

SCHOENMAKERS ADB operates in emerging markets and, as such, I very much relate to what Stefan has said. The burden of proof and transparency needed for all this sustainability issuance is quite high.

As such, yet another labelled product – like a transition bond – won’t be very welcome because the a mount of resources needed to cope with the existing demand from investors, and potentially also  regulators, is already high. Even though we are, in a sense, exempt from regulations, we understand investors are seeking the information required. It is tough given the limited availability of data.

RUDGARD We are totally aligned. What we need is disclosure at the issuer level.

DAY We generally have a more sustainable focus, although transition is also very important to us. Two of our sustainable funds are now investing more directly in labelled bonds. I agree with Anna that it is much more about the whole entity than a label. Direction of travel and trying to encourage good behaviour are the most important things for us. 

FISHER I agree. Additionally, for investors committing to net zero via an investor initiative guided by the Net Zero Investment Framework, one of the recommended actions is to assess the alignment of issuers with the net zero pathway, including the evaluation of decarbonisation and capital expenditure plans.

Of the criteria used in the alignment assessment, the one we find more challenging to obtain is the capex plan. We haven’t yet come across a third-party data solution that includes a capital allocation assessment in the overall alignment assessment. 

RUDGARD It is recommended but getting the actual data is not there yet.

DAY Green and sustainable bonds is far too narrow in focus. In the green bond issued by the AOFM [Australian Office of Financial Management] recently, the focus on CO2 reduction over other issues was interesting to see. From my perspective, water usage, and wildlife and forest depletion are areas where Australia could take a global lead.

SCHOENMAKERS There are also investors that just want their money to be dedicated to certain projects or sub-portfolios of an issuer, which we as an issuer like to accommodate. I agree, though, that in a perfect world it would be possible to just download the data and get a perfect view of where an issuer is. 

RUDGARD Correct. And this is the unique part of investing in fixed income from a sustainability perspective – the ability to direct the funding toward specific green or social projects.

IRISIK SLBs have often posed issues for us relating to visibility on the use of proceeds, or rather the lack thereof. Because of this, we were unable to allocate these bonds into our Global Green Bond Fund. This article 9 fund has a strong focus on addressing challenges related to climate change, the protection of ecosystems and preventing the loss of biodiversity, where proceeds allocated to these projects are transparent and traceable.

Surprisingly, ESG [environmental, social and governance]-focused funds experienced negative inflows for the first time on record last year. This was primarily concentrated in global ESG equity funds, which underperformed compared with conventional equity funds. However, the fixed income space tells a different story. Here, inflows into sustainable funds – or lighter green strategies – have more than offset outflows from stricter article 9 funds – darker green strategies – this year. 

Significant resources have been spent by issuers and investors in developing the ESG market. But, as the case of SLBs shows, more effort needs to be made to boost transparency and credibility, thereby  reducing the risk or perception of greenwashing.

ESG assessment forms an integral part of our investment process, even for conventional bond funds. We favour sustainable issuers across all our funds, not just those specifically dedicated to ESG. Nikko has a long history of investing in green bonds and other labelled sustainable instruments, reflecting our longstanding belief that sustainable investing will one day become a crucial component of responsible fixed-income management globally, as it has already begun to do.

RUDGARD As an investor, it is really helpful to have standardised disclosure. Especially in sustainable finance, at the moment everything is reported in different ways, under different metrics and with different reporting formats. Adopting ISSB [International Sustainability Standards Board] standards is one solution to this.

There is a balance, but globally recognised disclosure projects are really helpful for us as investors when it comes to increasing transparency and gaining a better understanding of what is happening at the issuer level.

HELLERUP We are happy to provide the information but we also need to get the data. Big corporates might have the data but the SME sector does not. I agree that transparency is good but we need the data. This is the biggest issue in the sustainable finance market. 

GOEBEL If there was really a global, reliable sustainable finance disclosure regime, why would we have any labelled bonds on top of it? If we can readily download the information and score overall activities so we can say a company is best in class, or close, or improving, would we need any labelled bonds? Or are labelled bonds rather a product of necessity, as long as we have a lack of information?

BILL It is worth adding that labelled use-of-proceeds bonds arguably offer more transparency.