Rates investors back Australian high grade

Rates uncertainty is being driven by some data points suggesting the Reserve Bank of Australia (RBA) may not have gone hard enough against inflation. Australian CPI accelerated at its fastest pace in six months in May, rising by an annualised 4 per cent. This was up from 3.6 per cent in April and beat forecasts of 3.8 per cent. The trimmed mean also hit a six-month high.

This led to a general creep tighter in medium-term rates expectations. The baseline expectation by July is that there will be no cuts in 2024 and the market is divided on whether the next move will be a cut or a hike.

These developments were emerging at the same time as the European Central Bank made its first rate cut and shortly before the Reserve Bank of New Zealand dialled back the hawkish rhetoric in its monetary policy statements. Taken at face value, it might seem that Australia is still in tightening mode even as much of the rest of the developed world enters a cutting cycle.

But the consensus analysis remains that apparent divergence in central bank paths is most likely a temporary phenomenon. And if there is a realistic prospect of a divergent higher-for-longer rates narrative in Australia, it has so far had a muted impact on the domestic high-grade market.

The bigger trend, investors say, is still for lower rates in Australia next year as the economy shows signs of weakening. It grew by just 0.2 per cent in the final quarter of 2023, according to the Australian Bureau of Statistics, and 1.5 per cent over the course of the year getting slower each quarter.

In fact, buyers that had already been loading up on Australian sovereign-sector paper after semi-government spreads widened significantly on heightened supply expectations following the May-June budget season have largely only strengthened their resolve to participate in the sector.

What divergent views have done is facilitate demand across the curve. On one hand, some buyers had begun to naturally reposition out of long-dated bonds and into short-dated federal debt thanks to higher outright yield. Offshore life insurance accounts, for instance, can now meet their hurdle rates with much shorter-dated Australian Commonwealth government bonds (ACGBs). These investors do not need to reach for yield with longer-dated product such as semi-governments, suggests Vojin Vujacic, portfolio manager at Modular Asset Management in Singapore.

On the other hand, asset managers emphasise that Australia remains one of the only steep, forward-sloping yield curves among developed markets providing a natural incentive to go long.

For instance, Lukasz Irisik, senior portfolio manager at Nikko Asset Management in London, tells KangaNews 12-15 year semi-government paper is particularly attractive especially in the context of its improved liquidity, which has been strengthened by a number of Australian trading desks in the UK that can now support liquidity in European time zones.

The liquidity issue plays out differently for issuers across the semi-government sector, because not all names have the scale or budget outcomes that require the size of funding requirement that has driven turnover for the largest states. In the case of smaller issuers, scarcity value is providing value (see box).

For bond investors, the best course for Australia is the fabled soft landing: an economy that is weak enough to Fallow for – or demand – rate cuts without protracted recession. The signs in mid-2024 suggest this outcome is still possible, investors say. For instance, the labour market remains robust – and while Irisik suggests the workforce is starting to show signs of easing it is “not as much as one would expect at this stage in the tightening cycle”.

The risk may be on the downside. ANZ research published on 22 July notes: The ratio of job ads to the labour force fell by a similar magnitude between 2010 and 2013 and the unemployment rate increased by around 1.5 per cent, although with a lag of 6-12 months. A further 0.9 per cent increase in the unemployment rate from its current level would put it at 5 per cent, well above the RBA's estimate for full employment.

Whatever the outlook, investors across jurisdictions tell KangaNews they remain bullish on the Australian sovereign sector despite a challenging fiscal backdrop for many issuers driven by elevated borrowing at a time when interest costs are high.

The semi-government sector expects to raise around A$100 billion (US$67.3 billion) in the 2024/25 financial year, for instance more than the Australian Office of Financial Management's target of A$90 billion.

This is the second consecutive year in which the aggregate semi-government issuance task has outstripped the sovereign and market users say this is a primary reason why semis have, as a group, repriced wider.

For instance, Queensland Treasury Corporation (QTC) announced its funding programme on 11 June before pricing a A$1.5 billion tap of its July 2036 benchmark just over three weeks later. The deal priced at 90 basis points over ACGB and 100 basis points over futures, reflecting a 22 basis point and 20 basis point widening versus a 6 March tap of the same line. Demand was not an issue: QTC capped the size of its 2036 tap but still lured investor orders of more than A$5 billion.

This type of spread to sovereign has already attracted demand to a subsegment of the global supranational, sovereign and agency (SSA) Kangaroo issuer base in 2024. The semi-government sector offers an arguably better proposition given its credit profile and improved liquidity, says Steven Williams, head of global fixed income, EMEA at Nikko in London. He views the Australian states as being priced purely for liquidity risk rather than credit risk.

The positive investor outlook is certainly evident in the primary market, as a clutch of deals joined QTC in the market around budget time. For instance, South Australian Government Financing Authority achieved its largest ever book, at A$4.6 billion, for a A$1.5 billion 2031 transaction priced on 6 June. The semi-government complex syndicated a total of A$12.8 billion in less than two months from mid-May.

Well-received deals typically beget more well-received deals, issuers say, despite funding windows being increasingly constrained by economic data. Consistent supply also assists sector visibility – some states report around half a dozen new investors coming into each of their syndications in recent months.

Aside from yield, there might also be a more bullish approach to foreign exchange and central bank reserve managers thus allocating more to Australian dollars once more – having run lower allocations in recent years as the RBA rate cycle lagged its international peers.

Investors have been generally positive about Australian fixed income. Day tells KangaNews he has been long Australian debt, supported at macro level by the fact that federal debt on issue remains low compared with the US and Europe. Day explains that, on a hedged yield basis, Australian high-grade credit is particularly attractive due to a combination of the steep curve and the pick-up in yield versus currencies such as US dollars and sterling.

"When spreads are this wide, semi-government names become good investments on an absolute yield basis," Day continues. "Achieving 5.5 per cent yield – which is currently 200 basis points above inflation - is no mean feat for a long-term investor, regardless of whether there is an additional rate increase from the RBA."

While elevated borrowing naturally provokes jitters from a ratings standpoint, investors argue the fundamentals for Australian semi-government names, and their credit quality, also stand out in a global context. There is also the issuance outlook, under which the biggest semi-government names are largely predicting their funding requirements to ease over the coming years.

"The backdrop for the fixed-income asset classes is, in general, still healthy," says Tim Hext, head of government bond strategies at Pendal in Sydney. "Yield levels look attractive right across the Australian curve. The market reflects higher-for-longer rates already, and when investors look back in five years' time, the likelihood is they won't regret buying."

Investors point out that global peers, such as the Canadian provinces, typically have tighter spreads in their home markets than the Australian states. While supply pressures are just as present for the Canadians, provinces are more active in foreign currencies adding the boom of Australian dollar opportunities to issuance in Swiss francs, euros, sterling and US dollars. According to RBC Capital Markets, offshore funding represented 20 per cent of Canadian public sector issuance in 2023.

The Australian states are active in foreign currencies but typically only for small, long-dated, privately placed transactions. Whether wider pricing domestically makes offshore issuance seem more attractive is an open question, but for now investors are happily accepting the wider spreads on offer in Australian dollars.

Many have been adding to the semi-government sector from other asset classes. Irisik says the rally in equities and credit this year has led to tighter SSA spreads, and he has therefore reduced his allocation to agency names like BNG Bank, Kommunalbanken Norway and NWB Bank while taking advantage of the spread widening in the semi sector to buy Australian names.

"Over the last 10 years, the semi market has only grown in prominence and liquidity," Irisik says. "The breadth of the market has also improved significantly. With traders now offering tight bid-offer spreads in our time zone, there is no real downside to trading these names. We get most involved at the time of new issuance in the primary market, particularly if we are eyeing a large order."

Modular's Vujacic adds: "Issuing benchmark size in foreign currencies would offer multiple benefits to the sector. Foreign-currency issuance would not only help with funding tasks but could even embolden domestic investors, as an alternative backstop bid would be evident."

Hext argues foreign-currency issuance is of particular relevance as semi-government borrowing is projected to remain elevated for the next few years.

“When tasks are small and manageable, issuers can be choosy,” he says. “But when tasks are large they need to tap into as many pools of capital as possible. Australian bank issuers have already paved the way in this regard.”

Two decades ago, bank borrowing requirements ballooned and these issuers thus headed offshore to secure funding. Over time, they established consistent foreign-currency programmes.

While it might be more expensive to fund offshore on a per deal basis, Hext highlights the importance of prioritising “collective cost”. He explains: “Issuing more offshore brings competing demand that tightens domestic curves, for instance, and adds diversification of funding sources. Semi-governments have yet to change their models and still refer principally to 'opportunistic funding offshore’.”

Semi-government issuers do fund offshore – and the volume of bonds on issue can grow to a relatively substantial scale. For instance, Treasury Corporation of Victoria tapped its 2050s for €400 million (US$445 million) in January 2024 and it now has A$1.6 billion equivalent of foreign-currency notes outstanding.

But when it comes to benchmark trades, spreads remain unattractive for borrowers swapping funds back to their domestic currencies. Semi-government issuers cite cost as the primary reason to keep to the traditional domestic focus and they also do not consider domestic demand to be capped out. The states are therefore prioritising diversifying their Australian dollar investor bases.

Hedge funds, for instance, have been playing an increasingly significant role in primary books and the semi market overall, according to some issuers. Some ‘pods’ in hedge funds can exhibit qualities more commonly ascribed to asset managers, issuers say, including longer holding periods. Meanwhile, asset managers on and offshore have increasingly been exhibiting fast money traits, such as capturing new-issue premia.

In the medium term, investors that have supported the Australian semi-government sector are hoping to see relatively elevated spreads start to contract. In this context, one of the main risks is that ongoing volume of supply will ensure spreads remain elevated, hampering performance for investors.

A January 2024 RBA report shows that the volume of semi-government debt outstanding increased by more than 60 per cent in the 13 years to 2023. While annual net issuance of semi-governments was close to zero in the years before the pandemic, it increased to more than A$50 billion each year since 2020. This stands in contrast to the stock of ACGBs, which surpassed net semi issuance by more than A$90 billion in 2020/21 but has since declined, reflecting strong federal revenue and lower spending.

However, there is far from a consensus that more issuance is the only reason spreads have moved wider and, therefore, some confidence that the recent trend could unwind. Nikko's Irisik says asset-swap spreads widened as the RBA's A$188 billion term funding facility has rolled off. This led Australian banks to increase their purchases of semi-government bonds but, as natural hedgers who swap fixed for floating rate, their activity actually put further pressure on spreads, Irisik explains.

Meanwhile, secondary market turnover across the semi-government sector continues to increase year-on-year, creating a virtuous circle. Investors are attracted to a liquid market while the wider bid for high-grade Australian paper, particularly out of Asia, enhances trading. Nikko's Williams notes that the semi market is "far larger and far more liquid than the [Kangaroo] SSA market" thanks to the consistent flow of new issuance.

State borrowers still favour a small number of large bond issues, as does the sovereign, and – all else being equal – more issuance should mean more liquidity. But there are still reasons for caution. For instance, Hext says liquidity in genuinely challenging conditions has not been tested since March 2023.

He tells KangaNews: "The market spends most of its time in a state of 'good times' liquidity. One can have debates about bid-offer spreads and volume, but issuers and investors are able to access the market and get trades done. 'Bad times' liquidity is where the true definition of liquidity comes into play."

At the onset of the pandemic, very few assets cleared Pendal's liquidity hurdle: in fact, government bonds were the ones that did so. "Government bonds are lower-yielding because investors are required to pay a liquidity premium," Hext adds. "They are not just high-liquidity assets, they are high-stress liquidity assets."

Generally speaking, conditions in the bond market have been holding together for a long time but investors are keenly aware of the potential for a quick change in tone. "We have a broader depth of market participants now, particularly with the emergence of hedge funds. But liquidity has not been truly tested," Hext adds. "The last risk-off event was the banking crisis in March 2023. Here we are, over a year later, and there haven t been any other major cracks from higher rates. It is concerning that there is still risk out there and the market seems to be embracing it at an ever-increasing pace at the moment."