The macro signal this investor watches most closely

The Reserve Bank of Australia walks a fine line in trying to ensure the cash rate remains restrictive enough to temper inflation, without being so tight it risks bringing on a recession. We saw it again in the lead-up to the latest update, as RBA Governor Michele Bullock warned “the risks around inflation had risen”. 

Mullumby also delves into the State Street Floating Rate Bond Fund, discusses how his team manages risk, and answers the number one question about the asset class.

What is your base case for Australian interest rates from here?

We are still a firm believer that the RBA has done a very good job [and] has engineered a soft landing. But in engineering a soft landing, this means that you haven't broken the economy with too much in the way of interest rate hikes. They're very reluctant to ease.

It's a very fine line they’re walking, but you saw the inflation data yesterday was strong, and you see employment data consistently month in and month out. It's now got a 4-handle on the employment rate but is still historically very low. And any talk of the RBA easing, I think, is not justified.

But by the same token, we did think six months ago that if the RBA was to hike, they'd do another tranche of hikes. I think that if they were to hike, it would be a very high hurdle.

So, happy to say that they're comfortably on hold but that’s very data-dependent. If you continue to get strong inflation data, they'll be forced to hike.

But by the same token, if you get low inflation data and higher unemployment, it's going to take a while for them to ease, simply because of this very fine line they walk. I’m happy to say that in 2024, you're not going to see a lot of action from the RBA.

Which local market indicators are you watching most closely as clues for what’s likely to happen next?

We are very focused on the employment data. So even if inflation does come to the top of the band, which is between 2% and 3%, the RBA has been very clear that with the jobs market still roaring, with wage inflation still quite prevalent, with the unemployment rate being at three-point-something up until two months ago – now four-point-something – that's still very strong.

Putting that in perspective, pre-COVID, the RBA was talking about the NAIRU (the non-accelerating rate of unemployment), which was 5%. Even though we're now under 4.1%, it's still got a long way to go to not cause inflation more broadly in the market. Answering the question bluntly, we are very focused on the employment data. That is what the RBA is targeting to try and slow down inflation.

Term deposits are paying up to 5% but your floating rate fund aims to beat this. How much extra risk must you take?

We don't buy term deposits in our portfolio simply because they are totally illiquid, you can't break them. The yield they pay versus the illiquidity just doesn't stack up for us.

In senior unsecured bank loan rate notes, we run several portfolios that only buy those bonds, and they are delivering still markedly more than term deposits. They're very liquid, and the market's very big. Some names are easier to sell than they are to buy, but we target between 1% and 1.5% above the RBA cash rate and that's been achieved for several years.

They offer markedly more yield than the term deposits, which we are being shown. But by the same token, they are very liquid.

Answering the second part of your question, the risk is the spread-duration risk. Given some of these notes [have a maturity] of up to five years, if spreads move out markedly, that's where you mark to market. All your unrealised losses do stack up, so to speak.

But credit's still very solid. The banks are doing very well, the market is performing, so running inflation has been of benefit to the portfolio too, in addition to the spread that they pay over the [Bank Bill Swap Rate] BBSW.

You’re almost solely focused on owning bank-issued debt – what’s the main rationale for zeroing in on this sector?

The liquidity. As a very large portfolio manager, our cash book on any given day is north of half a trillion dollars, globally. And we have a credit team that is purely focused on the liquidity and capital preservation aspects of the banks we buy. We leverage off this very conservative, very respected credit team and we only buy names that they approve.

That's why it is banks only because the banks have proven to be very liquid in a distressed market. Other names, even some government bonds, mortgages and corporates are at times troublesome in a distressed market. But banks do trade, regardless of the underlying tone of the market, which again adds liquidity, which is what we’re all about.

What is the biggest potential risk for floating rate assets and how do you address this?

The biggest risk of any floating rate asset or any floating rate portfolio is duration. When spreads move out, if you are running very long spread duration in the fund, your mark to market, or your unrealised losses, will grow.

We deliberately run the fund with an average spread duration of less than three-and-a-half years. That's mandated. At the moment, we've running it for three years and that changes regularly. But the biggest risk is that spreads move out markedly, and that there is a market event, as we saw at the start of COVID.

The spread duration, or duration in general, is a measure of risk. The spread duration of a floating rate portfolio is the measure of risk and we do tend to wind that back if the market is wobbling. At the moment, it's not wobbling, so we're running well within mandates on the spread duration. But if the market deteriorates, if the market starts to get the jitters, we do deliberately wind back the spread duration to try and mitigate the interest rate risk in the portfolio.

What’s the biggest area of investor misunderstanding about floating rate bonds?

One point that is emphasised is that, given the name “floating rate,” the coupon changes every three months.

So, you buy these notes that have terms to maturity, whether it be one year, three years, or five years. But it's the spread that you buy it at that drives the price. Unlike a fixed rate bond, where you buy at a rate and it sticks with that coupon until maturity, floating rate notes adjust their coupon every three months to where the BBSW sets on the day of their reset.

We tell investors who are buying our floating rate fund that they will not receive the same coupon continually. It moves, along with both the BBSW curve and the reset dynamics of the portfolio.

Learn more

Simon actively seeks to invest in interest-bearing investments of high credit quality, rather than investing in a predetermined basket of securities such as an index. For further information on the Floating Rate Fund, please visit the fund profile below.

Managed Fund

State Street Floating Rate Fund

Global Fixed Income

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