Why you can’t set and forget in a changing rate environment

The global fixed income universe remains a valuable haven for client capital thanks to defensive and sustainable sources of yield from a diverse range of underlying asset types. That’s not to say investors and allocators can simply ‘set and forget’ their allocation to defensive assets. The interest rate environment is ever changing and this is having a profound impact on the relative attractiveness and underlying risk profiles of respective sub-asset classes.

For instance, Australian government bonds and long duration credit instruments have recently been beneficiaries of the growing expectation that domestic policymakers will shortly follow in the footsteps of most global central banks and embark on a new rate cutting cycle. Current market implied pricing assumes three and a half 25bps cuts in the official cash rate by July next year. We share a different view, instead opining that the resilient Australian labour market, sticky domestic inflation trends, and lower interest rate starting point means the start of a modest RBA rate cutting cycle is a story for the midpoint of 2025.

Fixed Income Yields

Yield-to-maturity, current vs. 3-years ago

The RBA’s own Chief Economist Sarah Hunter recently explained there’s no room for rate cuts until the labour market substantially weakens. This looks increasingly unlikely, particularly given government spending initiatives such as the National Disability Insurance Scheme (NDIS), which is driving jobs growth and above-trend wage inflation in non-market sectors such as healthcare, education and public administration. We expect local interest rates will remain on hold for at least another 6-12 months before the RBA embarks on a slow and methodical easing cycle, wary of the threat of a re-acceleration in core inflation.

As a result, we anticipate local bond yields will trend higher as rate cut expectations are pared back, putting pressure on fixed rate exposures such as government bonds. Instead, floating rate credit instruments such as subordinated debt and major bank hybrids look a more optimal destination for client capital given attractive all-in yields, solid underlying fundamentals and strong primary and secondary market support from yield conscious retail and institutional investors.

On the latter, we recently learned APRA intends to phase out Australian banks’ use of hybrid capital, concluding the high ownership of them among retail investors is a risk to financial stability, and instead wants to “simplify and improve the effectiveness of bank capital in a crisis”. Instead, APRA is proposing that banks replace the $43 billion of ASX-listed hybrids with a combination of common equity and tier-two bonds, which rank above equity but below senior debt in the capital structure. While the proposal is now open for discussion and feedback from market participants is welcomed, we get the sense that the prudential regulator will push ahead with the initiative, effectively banning any new issuance from 2027 and abolishing the market by 2032.

As a result, we think income focused investors will have to turn to alternative sources of yield in the years ahead to supplement existing hybrid holdings. High yielding credit strategies such as private debt, real estate financing and asset backed lending, look well placed to benefit from this development, however investors must be acutely aware they may be taking on increased credit, illiquidity and structuring risk when doing so. In our recently published “PRG Year in Review FY24” we detail the strict selection criteria we apply when assessing managers in these areas and highlight some of our preferred strategies in the space.

Australian Employment Growth by Industry

August 2023 – August 2024