Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 454

The forgotten asset class set to outperform in 2022

Against a backdrop of economic and geopolitical uncertainty, rising inflation and expectations of a rate hike, Australian investors are searching for investments that can benefit from these evolving market conditions.

With credit spreads at attractive levels, now might be the opportune time to have exposure to hybrids and credit. With minimal returns on cash continuing to underpin strong demand for hybrid securities, we anticipate demand for yield to remain robust throughout 2022, resulting in strong returns over the year for this asset class.

The upside of rising interest rates

Rising inflation, above average GDP growth and the unwinding of quantitative easing (QE) in 2022 has seen financial markets reprice interest rate expectations.

The rising rate environment will push the outright return on hybrid securities higher, without having a material impact on spreads given the strong economic backdrop. Given most hybrids are floating rate, investors will benefit via higher income from these rising short-term rates.

Strong balance sheets you can bank on

Australian banks are the largest issuers of hybrids domestically and their balance sheets are in fantastic shape, with capital ratios at historical high levels. COVID-19 provided Australian banks with access to cheap funding via the Term Funding Facility (TFF), which provided them with a degree of funding certainty and lower funding costs.

Following the withdrawal of the TFF in 2021, new bank issuance is coming to market at attractive credit margins, providing the ideal environment for active credit managers to identify the most positive risk adjusted opportunities.

For instance, bank senior credit margins are significantly off their TFF lows, which is leading to an attractive re-pricing across all bank capital issuance (refer to Chart 1). Overvalued growth sectors are likely to lead an equity market sell off similar to 2000 – 02, but are unlikely to impact credit market returns.

Chart 1: Bank senior credit margins – Well-Off Their TFF 2021 lows

Source: YCM/NAB/BBG –March 18, 2022

Fully protected from higher interest rates with high carry protecting returns

The higher the carry (running yield of an investment), the greater the protection it offers investors from adverse movements in credit margins. The carry for the Yarra Enhanced Income Fund (“EIF”) is currently sitting at ~3.0% above cash.

Based on an average portfolio maturity of ~3 years, we’d need to see an extreme 1.0% move wider in credit margins to wipe-out the carry. However, given the robust economic backdrop in 2022, we expect credit margins to remain relatively stable throughout, adding to floating rate credit’s income generating credentials.

This benign outlook is in contrast to the capital losses currently being observed in traditional fixed income due to the reset in interest rates and real yields. Usually, a rise in real yields will impact the value of everything long interest rate duration, from traditional fixed income to most equities. That’s not the case with floating rate credit, since its short duration offers protection to portfolio valuations from rising interest rates. This is observable in EIF’s outperformance compared to traditional fixed income (Bloomberg Composite Index) since February 2020 (see Chart 2).

Chart 2: Floating rate credit with carry continues to outperform fixed rate with little carry

Source: Yarra Capital Management, Bloomberg. As of March 18, 2022

Making the grade

In a world that seems to be getting riskier by the minute, investment grade hybrids look to be a safe haven for investors. Here’s why:

  • Investment grade hybrids appear to be fairly priced in an environment appearing increasingly more expensive, especially if real yields rise or normalise in a post QE world.
  • Investment grade issuers remain well capitalised, making them more likely to be able to service their interest payments and repay debt.
  • Most Australian investment grade hybrids are floating rate securities, which tend to pay higher yields if prevailing rates go up because they are based on a variable interest rate, rather than fixed. Not only does this mean more income when rates rise, but there is also no loss of capital.

 

Roy Keenan is Co-Head of Australian Fixed Income at Yarra Capital Management.

 

6 Comments
Alan B
May 03, 2022

Domestic and overseas shares and ETFs that focus on fixed rate securities are all falling in price, some by >20% since 2021, meaning capital loss. Hybrids and floating note bonds are all priced up above their issue price meaning the yield is low. I'm attracted to floating notes, just not seeing value opportunities.

Michael O'Rourke
April 23, 2022

It is fairly clear that ASIC is more focused on the uninformed consumer rather than the average retail investor, of whom they have very little knowledge. (ATO deals with SMSF's, and ASIC most likely doesn't understand how SMSF's work, as so many public "servants" access the very generous commonwealth super scheme).
The punitive approach adopted by ASIC in recent years to ensure compliance initially "glued up" establishing simple accounts and increased costs with no real benefit to investors. What caused the change on hybrids? What was the rationale? Are they worried there is a risk of systemic failure of our banking system? Surely Austrac know bank hybrids can be purchased on the ASX. Will the next step be that you have to be classified as wholesale to purchase shares which entail even more risk than hybrids?
Another commonwealth entity which seems to lack competence is Austrac. Why isn't their performance being questioned? Wasn't it "common knowledge" that high rollers in casinos might be an issue. Now years afterwards they are enquiring. The bottom line is that Austrac has not developed the fundamental tracking tools themselves but expect others should and happily impose costs on the wide range of investors for no real benefit. Crime is a problem but surely in these days of big data Austrac could do better and be held responsible.

CC
April 14, 2022

Floating rate securities are definitely the way to go in the fixed income part of one's portfolio

William Allan Cross
April 18, 2022

Funny how the minute that hybrids start looking attractive the big end of town influences the regulator to make purchasing new issues almost impossible for the little end of town.

David paine
April 21, 2022

As a part of the "little end of town" I have been totally miffed over the last couple of years with the examples where we have been attacked. This change from late 2021 you mention for hybrid issues is appalling for us.

Alexander Smith
April 22, 2022

It would be interesting to learn of ASIC's reasoning (or lack thereof) in their decision to allow retail investors to pay through the nose for quality hybrids on the secondary market, but block the little guys from participating in new issuances of those same company hybrids without the brokerage charges and price increases for good quality securities.

 

Leave a Comment:

     

RELATED ARTICLES

Rising interest rates and the impact on banks

Hey boomer, first home buyers and all the fuss

Opportunities across the capital structure

banner

Most viewed in recent weeks

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Welcome to Firstlinks Election Edition 458

At around 10.30pm on Saturday night, Scott Morrison called Anthony Albanese to concede defeat in the 2022 election. As voting continued the next day, it became likely that Labor would reach the magic number of 76 seats to form a majority government.   

  • 19 May 2022

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Latest Updates

SMSF strategies

30 years on, five charts show SMSF progress

On 1 July 1992, the Superannuation Guarantee created mandatory 3% contributions into super for employees. SMSFs were an after-thought but they are now the second-largest segment. How have they changed?

Investment strategies

Anton in 2006 v 2022, it's deja vu (all over again)

What was bothering markets in 2006? Try the end of cheap money, bond yields rising, high energy prices and record high commodity prices feeding inflation. Who says these are 'unprecedented' times? It's 2006 v 2022.

Taxation

Tips and traps: a final check for your tax return this year

The end of the 2022 financial year is fast approaching and there are choices available to ensure you pay the right amount of tax. Watch for some pandemic-related changes worth understanding.

Financial planning

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Infrastructure

Listed infrastructure: finding a port in a storm of rising prices

Given the current environment it’s easy to wonder if there are any safe ports in the investment storm. Investments in infrastructure assets show their worth in such times.

Financial planning

Power of attorney: six things you need to know

Whether you are appointing an attorney or have been appointed as an attorney, the full extent of this legal framework should be understood as more people will need to act in this capacity in future.

Interest rates

Rising interest rates and the impact on banks

One of the major questions confronting investors is the portfolio weighting towards Australian banks in an environment of rising rates. Do the recent price falls represent value or are too many bad debts coming?

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.