A broad range of risks are front of mind for investors as they are faced with multi-decade high inflation numbers, a sharp central bank policy pivot, and rising geopolitical risks with the Russia-Ukraine conflict turning into a prolonged war of attrition without a clear endgame.
These pressures will likely impact corporate margins through higher input costs, tighter credit conditions and weaker consumer confidence, which has already led to a significant readjustment in pricing across all asset classes in 2022.
Movements in Australian financial markets have been broadly consistent with global developments and the Australian corporate bond market has repriced the emerging risks faster, and more extensively, than equities. As shown in Figure 1, Australian investment grade corporate yields are now on par with equity dividend yields (first time since 2014).
Figure 1: Yield: Australian Investment Grade Corporates vs. Australian Equities
The decline in sentiment has been a powerful technical driver, with Global and Australian credit markets pricing credit risk premia similar to recessionary levels. However, corporate fundamentals and issuer behaviour hasn’t shown the deterioration which usually occurs before the onset of a recession and we’ve now seen spreads come in from recent highs.
Australian companies have low levels of leverage by global standards and they have maintained strong balance sheets by borrowing at low levels through the pandemic. We have seen AU$12 billion of bond issuance YTD in Australia which is well below the 2015-2021 average of AU$33 billion. Approximately 20% of companies on the Australian Stock Exchange have reported so far and initial results indicate that corporate profits, including the banks, remain intact.
While credit markets still face challenges ahead, spreads have largely reflected these risks. Lower quality, riskier credit is still vulnerable, however higher quality investment grade corporates and more specifically bank floating rate notes, offer good value at 170 bps of spread. The return outlook is at much healthier levels compared to the past decade providing attractive compensation to investors for risks and providing a good entry point for forward looking expected returns.
Figure 2: Forward Returns from Different Starting Spreads (%)
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