Appetite for Yield – Opportunities in Credit Markets

Interest rate securities remains our preferred asset class from a risk-reward perspective. High starting points for yields, reasonable valuations in credit and a supportive monetary policy backdrop bodes well for fixed income investors.

Preference for domestic

Within the asset class, we have a preference for domestic credit exposures which continue to perform well against a backdrop of rising interest rates, economic stability and solid corporate fundamentals. Primary markets have had no issues absorbing a spike in issuance. Recent debt offerings from corporates such as Telstra, Macquarie and Woolworths were each 3-4 times oversubscribed.

The level of demand highlights the appetite for yield, something we think is unlikely to conclude anytime soon. Large institutional investors such as superannuation funds are only now reaching historical allocations for fixed income after a prolonged period of suppressed interest rates.

At the same time, the yield opportunity relative to equities remains compelling. Recent strength in the domestic equity market has seen the dividend yield for the Australian equity market fall to ~4%, its lowest level since the aftermath of the pandemic. This can be attributed to falling dividend forecasts in the materials sector thanks to the increasing capital intensity of the transition to ‘green metals’; while a steady flow of passive money into the region has sent banking sector valuations to cyclical highs. We see this as an increasingly opportune time to rotate lazy equity positions into high quality credit instruments with sustainable income yields of 6-7% p.a.

Global trends

Within offshore markets, spreads (the difference in yield between credit instruments and government bonds) have tightened aggressively in recent months and now sit at their lowest levels since 2021. Investor enthusiasm for the asset class reflects the upbeat outlook for the US economy. This, in turn, bodes well for corporate earnings and balance sheets.

Credit quality remains healthy

Broad indicators of credit quality remain healthy, though we are starting to see some deterioration in fundamentals as the impact of higher interest costs and slowing economic growth take effect. To date however, this remains contained to the lowest quality segments of credit markets such as liquid loans and unrated credit. In addition, refinancing obligations are, in most cases, still 2-3 years away when interest costs are expected to be lower.

Duration matters

We remain reluctant to extend too much risk towards longer term securities such as government bonds due to lingering inflation risks and ongoing uncertainty around the timing of rate cuts. It is becoming increasingly clear that inflation may linger for longer than initially thought. This creates the potential for interest rates to stay ‘higher for longer’ and, in turn, place upward pressure on bond yields given the market’s expectations for rate cuts over the second half of the year.

Australian Credit Yields

Yield Premium

Credit Spreads: US Investment Grade and High Yield