The prospect of narrowing credit spreads has placed investment grade credit front and centre in portfolio construction as the higher-for-longer rate environment focuses attention on very attractive “all in” returns from fixed income.
Despite the potential for ~two rate cuts in 2024, it’s unlikely that official interest rates will revert to the depths recorded during the COVID-19 pandemic. In fact, interest rates now appear to be sustainably at levels not seen since prior to the global financial crisis (GFC).
Already, investors appear to be adjusting to this more normalised interest rate environment. In recent months, the attractive returns on offer from high quality investment grade credit has driven an unprecedented influx of money into new domestic corporate debt raisings.
Perth Airport’s recent $300 million seven-year bond, for example, was seven times oversubscribed as investors scrambled for an issue yield of 5.62 per cent. This is well over the historical average for a BBB-rated corporate issuers being ~two times oversubscribed.
Likewise, Macquarie Bank, in late February, secured record demand for a BBB-rated Tier 2 bond with an issue yield of 5.95 per cent.
Demand in both instances also reflects the quality of the issuing entities. Perth Airport, for example, is effectively a regulated utility with no real prospect of impairment.
Reminiscent of pre-GFC surge
Resembling the pre-GFC era, there’s a noticeable surge in demand propelling credit spreads lower, reflecting the compensation investors seek for favouring corporate bonds over government bonds. Since late-2022, US BBB-rated credit spreads have notably decreased, while Australian BBB credit spreads have recently followed suit.
This emerging trend bears resemblance to the market sentiment before the GFC, when interest rates mirrored today’s levels. During that time, investors were primarily attracted to the overall returns offered by higher interest rates, rather than focusing on the credit spreads on offer.
The all-in return of a bond is the sum of its base rate (typically BBSW) plus the credit spread, which fluctuates based on factors like the credit quality of the issuer and the tenor of a security.
The ongoing decline in credit spreads seems poised to persist, possibly reverting at least partially to pre-GFC times. For instance, bank credit spreads were considerably lower during that period: ~15 basis points for senior debt, ~50 basis points for Tier 2, and ~100 basis points for AT1.
It’s unlikely that spreads will return to such low levels. However, given the supportive macro environment, attractive interest rates and much improved Australian bank credit quality, there is certainly room for significant credit spread contraction throughout the remainder of 2024.
Equity-like returns
The upshot is that the current environment is conducive to holding investment grade credit as narrowing credit spreads are likely to result in additional return from increasing capital values. For example, if an investor holds a five-year bond with a 6 per cent coupon and the credit spread narrows by around 20 basis points over a 12 period – then the total return over that period is 7 per cent (6 per cent coupon + 5*0.2 per cent).
To put it into further context, investment grade yields today are not much lower than the total returns from equities and residential property over the past 10–30 years. This reality is driving demand for Australian credit from not just local investors – but also from global investors enticed by the yields on offer.
The market is likely to outperform across the board – but from a risk-adjusted return perspective, major bank tier 2 securities may prove a particularly strong source of outperformance, as potentially will residential mortgage-backed securities.
Now is perhaps the most opportune time in recent years for investors to step back and carefully consider the yield and diversification benefits that investment grade credit can bring to a portfolio.
Phil Strano, senior portfolio manager - credit, Yarra Capital Management
