Yield direction and volatility
Australia’s 4Q13 CPI, released last Wednesday, was surprisingly strong and caught local markets off-guard, despite having been preceded by a strong TD Securities Inflation Gauge two days prior. The headline index rose 0.8% quarter on quarter (2.7% year on year), which was twice that expected by economists. The strength was broad based with the Trimmed Mean figure (the one followed by the RBA) rising 0.9% quarter on quarter (2.6% year on year). Markets reacted aggressively, with 10-year swaps and bond yields rising over 10 basis points (to 4.58% and 4.17% respectively) and the Australian Dollar rising 1% to nearly 89 cents against the US Dollar. The higher than expected inflation print makes it less likely that the RBA will be acting on its easing bias any time soon and some economists are now calling for the next move to be a hike.
These yield and currency moves were entirely erased by the end of the week as slow growth in China, prospects of further tapering of the US Quantitative Easing (QE) program, and the devaluation of the Argentinian peso took their toll on growth expectations locally. In fact, the Australian dollar traded below 87 cents on Friday night before recovering somewhat this week (currently 87.56).
In the US, the FOMC is currently meeting and will announce a decision regarding policy (including QE tapering) tonight.
Outlook for inflation linked products
Last week’s CPI reading leaves no doubt that inflation will be a core concern to RBA policy in the near term. Presently, nearly half of economists polled by Bloomberg are calling for rate hikes in 2014, with the majority of these predicting multiple moves higher over the course of the year.
But the RBA cannot use inflation in isolation in its decision making, and indications on growth are pointing the opposite direction. Earlier this month we were shown a less than ideal employment picture, with a decrease of 22,600 in the number of people employed. The combined impact has meant lower medium term rates and a flatter yield curve since the start of 2014. So pundits expecting higher inflation to translate into negative impacts on fixed coupon bonds (or for that matter, positive impacts on floating rate notes) have so far been premature.
The outlook for interest rates may be uncertain, but one aspect is clear: the key factor that will drive rates higher is an increase in the rate of inflation. This would bode well for inflation linked products: capital indexed bonds (CIBs) and indexed annuity bonds (IABs). With coupons and principals increasing with inflation, these products will benefit even while the juxtaposition between inflation and growth persists.
Regular readers of The Wire will know we have been broadcasting the relative value of inflation linked products over much of the past year, and investors are now starting to reap the benefits. There are still a wide range of opportunities available across the entire spectrum of credit quality. Here are a few that stand out (margins quoted are yield to maturity) :
Table 1
Note: securities in red are available to wholesale clients only
Bendigo and Adelaide
FIIG will add the recently issued Bendigo and Adelaide Bank Limited Floating Rate Note to the direct bonds list today, which traded in the secondary market last week. The issue, which was only available to wholesale clients in the primary issue, is open to both retail and wholesale clients in the secondary market. The line pays a coupon of 2.80% over the 3 month bank bills swap rate (BBSW) and has a call date of January 2019 and a final legal maturity of January 2024.
This issue represents a welcome addition to a limited supply of medium term floating rate notes in our market. The bond has increased in price since being issued, and although supply is currently accessible, it is likely to become difficult to find in the near future. The current offer level is BBSW plus 2.33%, which equates to an implied yield of 5.96%.
Other credit margins and trading activity
Trading margins decreased modestly throughout last week, most notable of which was the AMP Group Finance Services Limited Floating Rate Note (FRN) December 2018 issue, which traded 30bps tighter since its issue margin of +265 in early December 2013. The trading margin contracted 3bps across the week as appetite for retail paper was also spurred on with the launch of the Bendigo and Adelaide Bank Limited FRN January 2019 issue.
Inflation linked securities were highly sought after last week in response to the high inflation data released, with $14.5m in turnover across the top lines traded. Still the most popular in the inflation linked space were both the Sydney Airport 2020 and 2030 capital index bonds (CIB). Supply remains good in both lines at yields of 6.30% and 7.10% respectively.
Ale Finance Company Pty Ltd 2023 CIB line, which can be hard to source at times, made a timely appearance last week with $3m in turnover traded. Supply remains good at the moment and at the current indicative offer yield of 5.55%.
There was also strong demand in the inflation annuity bond (IAB) space, and clients were spoilt for choice as supply across several lines became available. In similar timely fashion, the JEM NSW Schools 2035 line was sourced and turned over $2m, however at the moment there is only immediate supply in the JEM NSW Schools 2031 IAB line. MPC Funding 2025 and 2033 remain in excellent supply at yields of 5.65% and 6.30% respectively.
Away from the inflation bonds, the Tier 1 lines were also popular for the week, with $22m in turnover traded. In particular the Rabo fixed and floating lines maturing in December 2014 were well bid for in the institutional space as the call date becomes closer. Similarly the National Capital Trust FRN September 2016 line rallied in price as clients took profits and switched in to other bonds.
FIIG originated issues were actively traded over the week, with the Cash Converters (CCV) September 2018, Payce December 2018, Silver Chef (SIV) September 2018 and G8 Education August 2019 fixed rate lines all making the most traded list. Supply remains accessible in most of the lines; however SIV demand has started to outstrip supply as it remains popular amongst retail clients. Likewise demand for the PMP October 2017 line has outweighed supply as bids remain unfilled.
Notes:
Offer levels are indicative as at 28 January 2014 and subject to change based on demand and market movements.
Yields for floating rate notes are estimated as the sum of the swap rate to maturity / call and the trading margin.
Yields for capital indexed bonds and index annuity bonds are estimated as the real yield plus a 2.50% inflation assumption.