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Written by Matt Kirk Published: May 6 2020 Investments
RIM Securities research has recently noticed that floating rate coupons and lower credit ratings now make up a larger portion of aggregate bond portfolios (1). The shift towards A-, BBB- to BBB+, and below investment grade bonds, took place after 2013.
Shift in Credit Preferences
Floating rate coupons would benefit from a higher interest rate regime but how will bonds in the A- to below investment grade range behave if interest rates increase? No one knows for sure although examining past behaviour is one way to start to explore possibilities.
Recent History of Corporate Bond Spreads
A and BBB rated bonds displayed a higher yield volatility than equivalents with a less risky credit rating according to the chart produced by the Reserve Bank of Australia (RBA). Note the jump in risk premiums after 2007 in the chart below (2). The risk premium is the spread above the government bond rate (i.e. the representative for the safest market offer).
The Global Financial Crisis (GFC) of 2007 and 2008 is an instructive episode for its extreme effect on global financial market confidence. Yields for A and BBB rated bonds jumped the most which means prices experienced the largest falls. All yields eventually followed the downward trend in interest rates as confidence returned to financial markets and the RBA cash rate settled at historic lows.
Credit related spreads did not settle at pre-2007 levels. The ultimate profit effect would have depended on when the bonds were bought and sold, or if they were held to maturity. Fixed coupon bondholders who held on through the global financial crises, or bought soon after 2009, were rewarded by the lower interest rate regime.
RBA Interest Rate Dilemma
The RBA lowered interest rates to levels not experienced in recent history to compensate for the pressure on economic growth. Mining infrastructure investment slowed in late 2013 after making a contributed to total GDP not seen since early last century (3).
Mining infrastructure investment slowed as the focus shifted from capacity building to extraction. The transition was anticipated by the RBA. Unfortunately, the Federal government was not well prepared for this eventuality. Lower interest rates allowed housing construction to fill some of the slack; however, this created the risk of a housing bubble.
Rate Risk Bind
Higher interest rates pose a risk to export growth as they could strengthen the AUD at a time when the Australian currency is showing remarkable resilience. The housing construction sector would feel the pressure too. But persistent low interest rates could end in a severe residential property price correction.
Meanwhile many SMSF Trustees are tasked with the need to generate sufficient income for beneficiaries living in retirement. Trustees invested in floating rate A- to below investment grade bonds might be picking up yield on the expectation of persistent low rates while the floating coupon acts as a hedge against the possibility of rate increases. The positioning suggests the expectation of credit losses might not be high. Other SMSF Trustees might expect the spread (i.e. risk premium) between government bonds and BBB bonds will shrink further. The next blog in this series will examine contemporary drivers of interest rates and credit risk more closely.
About RIM Securities
Securities Limited is one of the best kept secrets in Australia and acts as the fixed interest engine for Australian investors by sourcing and executing fixed income securities. The business has established itself as a leader and key player in defensive assets placing in excess of AU$15 billion over the past 12 years. The firm is Brisbane-based and was established in 2004. It is majority owned by Trustees Australia (“TAU”), which became listed on the ASX in 1987.
(1) https://cashwerkzblog.wpengine.com/shifting-risk-preferences-part-(2) http://www.rba.gov.au/chart-pack/interest-rates.html