You can't simply wait this out in cash

Today's income investors might be forgiven for thinking the old certainties are not only upside down but all over the place.

It's bewildering. Asset classes that once seemed watertight have sprung a slow leak as central banks the world over attempt various magic tricks to charge their economies.

In this wire, I answer some of the key questions the team at Realm is facing and explain what's causing that hissing sound as cash assets deflate.

For example, I'll look past the reopening to see how today's flood of cheap money could be mopped up and inflation might again become a thing.

I'll also elaborate on why I suspect bravery will be punished, argue the case for being involved but sitting tight, and discuss why investment duration is a key risk factor and sliding a little down the quality scale might be in order.

You can't simply wait this out in cash, you could be waiting a very long time

The most important thing my team is debating right now 

The banking system finds itself awash with excess cash. In Australia, household savings and the Reserve Bank's Term Funding Facility have added more than $300 billion of excess funding in the last two years.

This is unprecedented in this country. Could it be the new normal? We have seen banks turn away from inter-bank and institutional funding. Ninety-day bank-bill swap rates have dropped to nearly zero and senior unsecured debt issues in Australian dollars essentially stopped more than a year ago.

Meanwhile, term deposit rates have also evaporated, punishing retirees and the risk-averse alike.

What we are focused on is how will this environment evolve in the next two years? What is the likely impact on deposit rates, interbank funding levels and credit market performance?

As the economy re-opens, it is likely that the excess savings will abate, slowing the build-up of liquidity from depositors.

At the same time, the RBA’s Term Funding Facility must at some stage be refinanced. This will mean that $200 billion must go from being funded by the RBA to depositors and debt investors.

In addition, the Australian Prudential Regulation Authority's announcement relating to the Committed Liquidity Facility will require banks to refinance about $140 billion in financial assets in the coming years.

All of this points to a reversal of the recent trend of central banks flooding markets with cash.

As this abnormal liquidity is reversed, spreads can be expected to gradually widen, but the mountain of savings created by Australian businesses and households in the last two years of lockdown will dampen this effect.

Household savings rates will moderate as we start to open up but the $200 billion in excess deposits created since early 2019 is a lot to unwind. This will offset a good deal of the impact of the RBA withdrawing liquidity.

This sets the market up for a controlled softening in domestic credit markets. Although the trend is turning, the environment remains supportive for banks and issuers alike.

Investors shouldn’t be expecting a material sell-off, barring any unforeseen events.

Implications for credit market investors

The compression of credit spreads in the last year has delivered solid returns for investors, crunching total real yields into negative territory.

With credit spreads at record lows, any widening increases the risk of negative total returns over the next 12 months.

This coincides with a technical environment that is about to get less supportive for credit markets, as we've discussed.

We're in a market that's less about finding outright winners and more about making yourself a small target. Investors should avoid outright directional credit bets, which means avoiding longer maturities.

At the same time, reopening of the economy, high excess savings and strong employment mean systemic default risks are very low.

To our way of thinking, this means investors can go down in credit quality, as long as they maintain a lower level of leverage to absolute changes in spread levels. This means staying very short in term risk.

How are we positioning our fund to take advantage of this?

You need to be involved but you don’t want to be overcommitted. While our thesis is that credit markets will soften and spreads are likely to widen, we think this will be modest.

We expect this could lead to negative returns at the longer end of the high investment grade curve and potentially in major bank 5 year senior unsecured debt.

The savings glut is not simply going to evaporate in a year, however. Savings rates are likely to stay above the long-term average.

All this means that banks are going to be less reliant on capital markets, both domestic and offshore.

This will reduce transmission risks when offshore credit markets sell off but, more to the point, deposits will continue to meet the majority of bank funding requirements. This factor will likely limit any kind of serious sell-off.

Barring unforeseen events, the market is not likely to snap wider to pre-COVID funding spreads. This means investors need to be involved. You can't simply wait this out in cash – you could be waiting a very long time.

By the same token, you are just not being compensated for those ever-present unknown unknowns. This means minimising your portfolio exposure to widening credit spreads.

As such, we prefer to maintain a maturity profile shorter than our historic average.

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Finding fair value in an otherwise expensive market

Investors should not be sticking their necks out in this environment. Market conditions have prompted investors to compress credit curves all over the world and heavily discount most complexity and liquidity premiums. That said, there are still a small number of narrow opportunities in credit.

Private residential mortgage-backed securities and asset-backed securities offer more attractive value than public RMBS and corporate bonds more generally.

A largely supportive economic environment combined with solid domestic property markets means that concerns relating to systemic solvency are low.

This means investors can buy with some level of comfort into the shorter end of RMBS and ABS curves, even at sub -investment grade credit ratings.

Beyond that, we like a select group of names and sectors. The COVID recovery trade has already compressed heavily but a small number of laggards present an opportunity.

Qantas (QAN) continues to trade closer to the BB credit rating curve, despite holding a BBB rating.

The position isn’t without risk but given how well management navigated the crisis, and the capability and conservatism of the company's accounting division, we remain confident in Qantas's ability to see its way through the malaise and maintain its credit rating.

The subordinated debt of Scentre (SCG) is also interesting. The market has punished the company because it is Australia-centric. US retail property names have not been hit so hard.

With a spread of close to 2.8% over 10-year treasuries, the security registers fair on our metrics in an otherwise expensive market.

Other contrarian opportunities include names like AMP (AMP) and Crown (CWN). Both have been heavily impacted by management, rating agency and bank syndicate concerns – not without reason – but both present reasonable value despite the inherent risks. These positions sit at 1-2% of our total fund size.

Heavy concentration is to be avoided when investing in sector or name-based opportunities.

The shorter end of the tier 1 bank capital market also looks reasonable. The 2-3 year term to call compares favourably with other forms of bank capital, particularly the shorter end of the tier 2 market.

All of these opportunities maintain a reasonable running yield. This will be important in a market in which capital prices soften once monetary accommodation is withdrawn.

What headwinds are we facing?

In one word: inflation. Compressed rates and low term premiums make markets exceedingly vulnerable to a shift in the narrative or any kind of normalisation in interest rate expectations.

Investment grade and sub investment grade credit yields are delivering negative real returns. There has been nothing like this in more than 40 years and markets are pricing assets as if it will continue.

Credit markets will be particularly vulnerable if inflation is not transitory in line with the base case of central planners and the investment community.

Rising inflation could sideline central planners and cause a material pick-up in long rates and term premiums.

This could present significant challenges for credit markets, especially at the longer end of the curve.

In this scenario, all bets would be off. We'd expect a more material weakening, whereas we currently project a moderate widening in spreads.

This increases the risk of a correlated sell-off, in which government bonds and credit would be sold simultaneously. The diversification benefit from government bonds would become a risk multiplier, magnifying losses further.

To be clear, this is not the base case. That doesn’t mean inflation is implausible, however.

Portfolio positioning needs to allow for inflation to overshoot and credit to correlate with rates. Credit managers should reduce their reliance on interest rate duration as a hedge.

The tightness of prevailing pricing highlights how vulnerable markets are to a shock. Positioning provides the best mitigation in these conditions. 

It's important to be involved, but given absolute market levels, you certainly don't want to be overcommitted.

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Managed Fund

Realm Strategic Income Fund - Enduring Units

Australian Fixed Income

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