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JULY 2021



As a consequence of the COVID pandemic, and the resulting economic lockdowns, the Reserve Bank of Australia’s (‘RBA’ or the ‘Bank’) monetary policy settings were set to the equivalent of DefCon 1, extraordinarily accommodative.  The aim was to offset the ravages of the COVID virus on households, business, the government and overall broader economy.  Accommodative monetary policies traditionally have the effect of sending interest rates lower, and this is what happened, plunging to all-time lows.


A year and a half on from the onset of the pandemic and it is arguably mission accomplished for monetary policy, or if not, then not too far away.  The economy was on course to move through the recovery phase, and onto the expansion phase, however recent Delta variant driven lockdowns will likely delay, but not completely impede this transition.  Unemployment rates have fallen to pre-pandemic levels, growth rates are back above trend – although again some lockdown headwinds will moderate growth, and after many absent years, inflation is re-appearing in the narrative and the data.


Looking through the latest lockdowns, time to pare back monetary accommodation is approaching, especially given extraordinary stimulatory fiscal policy measures still in play and persistent inflation concerns.  It’s just a question of when. The argument of whether the post-pandemic inflationary surge is transitory (consensus), or in fact something more entrenched, is a popular point of discussion, one that will likely persist for months to come.  Despite consensus favouring transitory inflation, and recent bond yields supporting such views, risk is to the downside (yields higher), negatively impacting returns on fixed rate investments.  FRN’s represent a viable option in the defensive space in this environment.


Monetary policy settings…

The RBA unleashed historically unprecedented monetary policy stimulus in a bid to counter the economic impact of the COVID pandemic.  The Bank deployed a suite of policy measures including emergency rate cuts (to all-time lows), yield curve control programs to keep the front of the curve low, and broader quantitative easing (‘QE’) measures to flatten the curve.  Further, mindful that bank wholesale funding may be hampered by dysfunctional markets, the RBA provided ADI’s with access to cheap funding through the Term Funding Facility (‘TFF’).  At expiry (June 30), the TFF was drawn to $188bn, equal to around a year and a half worth of average annual ADI wholesale funding needs (onshore and offshore).


Strong take up of the TFF, elevated retail deposit growth, and subdued credit growth resulted in banks having excess liquidity, giving them little need to access wholesale funding markets.  This is evidenced by an 18-month absence of major bank A$ wholesale issuance (senior) into local markets and the sharp growth in Exchange Settlement (‘ES’) balances.  ES balances, which represent bank excess liquidity held with the RBA, grew to $350bn, well above pre-pandemic averages of $3bn.


The RBA wants to normalise policies and reduce the extent of monetary accommodation in the system however, the Bank will remain flexible in the face of changing pandemic conditions and keep accommodation in place if needed.  For the time being, official rates remain at all-time lows, 0.10%, and are extraordinarily accommodative, and if we take the Bank’s inflation, growth and unemployment forecasts at face value, rates won’t change until the latter half of 2023.


Return to normal bank supply …

As I’ve mentioned, the major banks have been largely absent from local funding markets for quite a while now, and while regional banks have issued the odd deal, their volumes have been well below average.  For context, on average the four majors would issue A$22bn – A$25bn of senior paper into local wholesale markets, sometimes less depending on exchange rates and interest rate differentials.  In 2020 the four majors issued less than A$7bn, and in 2021 only one ANZ deal has been issued, a one-year line totalling A$1.4bn, which was purely to manage the bank’s maturity profile.  In addition to the lack of issuance, in excess of $30bn of ADI paper has matured, without replacement.


With the expiry of the RBA’s TFF facility, expected normalisation of household saving’s rates (reduced deposits) and increasing credit growth, banks are generally expected to return to A$ wholesale funding markets by the end of Q3 this year at the earliest, more probable in Q4.  While A$ supply will likely put some widening pressure on spreads, the above absence of issuance and bond maturities has seen a meaningful fall in the volume of outstanding bonds, demand for new paper will be strong, moderating any spread widening.


The scale of bank issuance will depend on the rate at which credit growth returns, and the pace of the post pandemic recovery.  Issuance will normalise in a volume sense, but it will be gradual.  Another consideration is the composition of issuance, with the majors especially still in need of tier 2 issuance to meet regulatory requirements between now and 2024 (the regulatory deadline).


Fixed vs Floating…

The outlook for interest rates for the remainder of 2021 is very similar to the actual interest rate performance through much of the first quarter of the year. The consensus forecast for the A$ yield curve by the end of the year is depicted below.



To gain a sense of how fixed rate credit portfolios might perform over the remainder of 2021 given the above yield curve forecast, we can look at how the AusBond Credit (Fixed) index performed relative to the AusBond Credit (FRN) index over the first quarter, and it was a -1.42% vs +0.08% respectively.  The AusBond Government Index (Fixed), which has a longer duration than the credit index, performed worse again, -3.6%.


In a rising yield environment, most benchmark aware fixed interest funds will target a lower duration position relative to their index.  Indexed funds (aka passive funds) will off course have to hug the index.  Regardless of actively or passively managed fixed interest funds, most will be expected to deliver negative returns over the remainder of the year.  By our estimates, the AusBond Credit (Fixed) index will generate a loss over the remainder of the year of -0.75% – 1.00% if yield curves track toward consensus forecasts.


It’s not all bad for ‘fixed income’ or bond investors.  In a rising interest rate or yield environment there are always floating rate note (FRN) options looking for capital stability and consistent, low risk income flows.  While coupon flows from a fixed rate bond are static at a set %, the underlying coupons flows from an FRN’s adjust regularly (every 30 to 90 days) with underlying rates.  We expect the AusBond Credit (FRN) index over the remainder of the year is expected to generate a positive return of +0.20% to +0.30%.


Here’s the sales pitch.  Mutual Limited specialises in credit funds, specifically populated with FRN’s.  The two core funds are the Mutual Income Fund (‘MIF’ – buys Australian Bank debt only), targets a net return of +1.20% above the Bank Bill Index.  For the financial year just ended, this fund returned +2.81% (net).  The other core fund is the Mutual Credit Fund (‘MCF’), which can buy additional AUD debt targets a net return of +2.20% above the Bank Bill Index.  MCF returned +4.41% (net) over the 2021 financial year.  Both funds are rated “Recommended” by Zenith Partners.  For a little more risk and return outcomes, Mutual also has the High Yield Fund, which targets +4.50% over the Bank Bill Index and returned +8.81% over the past year.


Please see Mutual Limited’s website for fund details or call 03 8681 1900.


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