Where to now for fixed income investors?

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The RBA joined seven other central banks in easing policy this month. The RBA cut the cash rate by 0.25% to 2.75%, revising inflation forecasts lower, and increasing the scope to cut rates again in the future. With the RBA inflation target range being 2% to 3%, another rate cut means investors are effectively getting 0% real returns at the cash rate.

Given favourable market conditions of low base rates and lower credit spreads, issuance activity in the debt capital market continued at a steady pace this month. So far in May, total issuance volume has been $8.6 billion, the second highest year to date, behind the $12.62 billion of issuance undertaken in January, as companies take advantage of favourable borrowing conditions.

The great yield chase

The Australian iTraxx Credit Default Swap (CDS) index tracks the performance of Australian corporates and is an indicator of credit risk for investment grade entities. The lower the spread, the lower the perception of credit risk. The charts below show performance over one month and one year. Over the last month, the Australian iTraxx tightened some 15 basis points and over the last 12 months has tightened just under 100 basis points.

This decrease in spread has occurred as investors have ‘chased yield’ driving the capital prices of bonds up. This chase for yield and decrease in risk perception, has seen bank spreads come in markedly over the last 12 months. The five-year CDS spread on NAB, for instance, has come in from 185 basis points 12 months ago to 72 basis points today. It’s still higher than pre-GFC, but bank funding costs have come down, and this is the reason why commentators are now discussing out of cycle rate cuts – banks can afford to sharpen their pencils and chase the loan market. With corporate sentiment remaining subdued, competing for the home loan market is the best chance of growth for the Big Four in the short term.

So where’s the value?

With spreads tighter and base rates lower, it is becoming tougher for investors looking to maintain a diversified investment portfolio to achieve solid returns. However, it is worth noting that the cut in the cash rate tends to have more effect on term deposits and short maturity bonds. Longer maturities take their lead from other, longer-term indicators. In the graph below we see the initial drop in the five-year AUD swap rate following the announcement of the rate cut. Two days later solid job figures were announced (a good sign) and the rate jumped up to above where it was the day before the rate cut (subsequent to this, in the absence of other data, the rate followed US movements as is the norm).

So for investors holding fixed income and who are confident that the low interest rate environment is here to stay, the message is to move out of shorter-dated securities and into longer-dated maturities where the base rate can help increase returns. A return in the 5% range may not sound great, but it is double the short-term rates on offer.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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