Layer cake anyone? Just like that, corporate bonds look attractive again.

Can it be that parts of the credit market look attractive again? Firstly, daring to suggest any aspect of fixed income looks cheap at the moment is about as popular as a coal miner at an ESG meeting, as the chorus grows ever louder for the end of the world as it concerns all things bond-related (yields going ever higher, etc. in the face of central bank flips and twists).

We are happy to be one of the lone voices there in any case, but what has caught our eye in particular has been the slow repricing of relatively high-quality investment grade bonds over the last 3 months. The repricing hasn’t been dramatic, like in March 2020 when spreads blew out and prices tanked, but slow and gradual.

The total return prospects for parts of this market look appealing over the next 1-2 years.

Investment grade bonds are essentially composed of 3 component parts when it comes to their yield with each part somewhat like the layer of a cake:

• Layer 1: A government bond yield
• Layer 2: A spread between the government bond curve and the interest rate swap curve (the swap spread)
• Layer 3: The credit spread between the actual yield of the bond and the swap curve (the credit spread to swap)

Each of these 3 layers adds up to an attractive slice.

Layer 1: Government Bond Yields

In the case of government bond yields, these have moved decisively higher over the last 3 months as markets have gotten tremendously giddy at the possibility of what central banks could do in 2022. If you believe the RBA will raise interest rates ~4 times in 2022 for a collective 100bps of hikes for example, this is now in the price.

If you believe this is overdone and highly unlikely to be realised (our view), government bonds are cheap.

If you think the RBA needs to slam on the brakes right now and go gangbusters, raising by more than 100bps, then there is further to go for yields.

In context, the 3 year government bond yield now sits 115bps above the prevailing RBA cash rate (which is of course still 0.1% and not moving anytime soon), the largest premium to official policy since the GFC. The chart below simply conveys that the RBA needs to start raising rates and raising them soon to justify the large gulf on offer in 3 year government bonds versus cash. For reasons which we have argued at length, we continue to not see this in 2022. Did I mention that the cash rate is still 0.1%?

Layer 2: Swap Spreads

Swap spreads. Swap spreads are one of the more mysterious parts of the bond market that usually remain the domain of the pasty looking fellow in the darkened room. In simple terms, the interest rate swap market creates the benchmark curve from which credit risk is normally priced. The market talks about swap spreads as simply the difference between the yield on an interest rate swap and the government bond of like tenor. Normally this swap spread is quite stable and doesn’t move much. Without investigating the many drivers of swap spreads, the chart below simply illustrates, using the 10-year, that spreads are close to the widest they have been in a year. The same is largely true across a range of maturities.

Layer 3: Credit Spreads

The final layer of the investment grade corporate bond cake is credit spreads over the swap curve. Or credit spreads. This is the real measure of return on offer for investors adopting credit risk as opposed to ‘risk free’ yields in the government and swap market. One way to gauge this is to look at the iTraxx Australian CDS curve which plots an equally weighted basket of 25 large liquid investment grade names in terms of their credit default price or spread to swap. Investment grade spreads as measured by the iTraxx index are closer to their wides of the last 12 months.

As per the chart above, credit spreads are wider but hardly massively and swap spreads similarly are maybe 10-15bps higher than long run averages.

But high government bond yields + wide swap spreads + wider credit spreads = the layers of the corporate bond cake have started to take shape into a rather tasty morsel.

Putting it all together, we are seeing aspects of the investment grade market looking as attractive as they have been for a while. Mid curve maturity bonds from high quality Australian utility and real estate issuers, as a small example, are trading at yields just under 3% for bonds with ratings in the single A or high BBB category. For those with a willingness to add a bit of duration, yields in the ~3.5% area are common. These yields reflect the 3 layers of the cake.

Did I mention that the RBA cash rate is still 0.1%?

Of course, higher yields means lower prices. In the case of the above 3 sample bonds, like many others, they are now trading well below their par price of $100. So, the return on offer is the coupon income plus the “assured” capital gain from buying a bond at say ~$95 and then seeing it regain its value back toward its par price. Obviously, if a borrower defaults, you won’t see your $100 but with the sort of borrowers we are considering, this risk is extremely low.

Of course, bonds like those above can become ‘cheaper’ in the short term (fall in price further) just as they have been doing over the last few months. Which would push yields higher and prices lower. But, again, total returns are looking compelling unless you believe that the alternative (cash) is going to catch up very, very quickly to remove the substantial yield advantage now on offer. By contrast, we expect yields to decline as the air comes out of the rate expectations bubble and we expect swap spreads to also narrow back toward their longer run averages.

Finally, we expect credit spreads to be more or less unchanged in the high-quality part of the market. So, all in all, the sector is expected to perform well over the next 1-2 years.

Ultimately, there’s no reason to believe bonds such as those above won’t return investors their coupon and principal of $100, despite currently trading at a discount. Someone once described that as money good.

We separate our duration or government bond active positioning from our allocation to corporate securities. But there is no question that the attractiveness of investment grade partly reflects the underlying pricing shift in governments.

Finally, we’d point out that not all credit is cheap. We are deliberately singling out some of the highest quality, most defensive names where credit risk is modest and the return (of capital over time) is highly predictable. The same cannot be said for riskier parts of the non-government market including high yield. 

Written by Chris Siniakov, Joshua Rout and me

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