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Mutual Limited CIO Scott Rundell discusses why the RBA hiked unexpectedly and what’s changed in their thinking. Scott also provides his view on whether more rate rises are coming.

On the latest Talk Ya Book, Chris Judd welcomes back Scott Rundell from Mutual Limited. Scott discusses the state of the banking system amid the recent turmoil, why the gold price has been moving strongly in an upward trajectory and whether the US Dollar can remain a global reserve currency.

Background The past week or so has been wild for global markets with some very wide trading ranges across bonds, stocks and hybrid securities, aka AT1. Offshore credit markets have also been volatile, and while we have seen some widening in local A$ credit, the moves have been relatively muted by comparison. The collapse of Silicon Valley Bank (‘SVB’) in the US and contagion effects represents ground zero for this saga and story of woe. While regulatory action was taken to stem the blood-letting, confidence on whether these actions were enough waivered from day-to-day. Eventually it appears all was good in the hood, but then more recent comments from US Treasury Secretary Yellen poo-pooing expansion of current depositor support programs have added to inter-day volatility. This will likely remain a moving feast for days, probably weeks, to come. Adding to the sense of impending market doom, early last week, the lights almost went out on Credit Suisse. After more than 160-years in business, the Swiss bank faced its own crisis of confidence, with visions of Lehman Brothers coming back to haunt markets. After a few days of angst and anxiety, the Swiss National Bank brokered a deal for UBS to acquire Credit Suisse. As part of the deal, however, a meaningful wedge of Credit Suisse AT1 capital was wiped out. Against the natural order of capital, Credit Suisse equity survived. Heads were scratched. With the risk of new financial crisis waning, I thought it constructive to conduct a brief post-mortem of recent events. Now, ‘Post mortem’, ‘noun: an examination of a dead body to determine cause of death.’ After last night’s comments from Yellen, one could suggest said body has a pulse. Nevertheless, I expect the worst is behind us and we’re seeing some involuntary death spasms… if that is in fact a thing. In the following piece I provide a review of Australian bank liquidity, and why we’re ‘different’ to US banks. I also look at the Credit Suisse situation, and why Australian bank AT1 capital, and Tier 2 capital for that matter is sound. Lastly, some commentary around how local bond and credit markets have performed of late. Before I proceed, a shout out and a gentlemanly tip of the cap to Brendon “Coop” Cooper at WBC who has published two very informative pieces on bank liquidity and AT1 dynamics recently. Some might be tempted to call my “borrowing” of his words as “blatant plagiarism”, however I prefer to term it as “para-phrasing with respect.” And, besides, plagiarism is the sincerest form of flattery. Australian Bank Liquidity Concern for Australian bank liquidity, particularly the regionals, stemmed from the situation that engulfed Silicon Valley Bank. Contagion risk, unfortunately saw other smaller US regional banks hit with deposit runs. SVB’s issues were not caused by any systemic shock, although the genesis of their downfall was rooted in the pandemic and monetary policy responses. The main cause was risk management incompetence – both at the bank level, but also within the US regulatory framework. To recap, through an absence of interest rate risk management, SVB left its balance sheet exposed to rising interest rates. A defence of SVB’s failings here, as weak as it is, is the fact they were not required by regulators to hedge interest rate risk. Under the Trump Presidency, regulatory hurdles for banks were loosened. As a consequence, SVB had no requirement to meet Liquidity Coverage Ratio (‘LCR’) or Net Stable Funding Ratio (‘NSFR’) minimums. Looking further afield, less than 10% of US banks (by total assets) are required to meet minimum ratio requirements in this regard. Australian banks on the other hand… “Australian liquidity rules (APS 210) apply to all ADIs through either the Liquidity Coverage Ratio (LCR) for large banks or the Minimum Liquidity Holdings (MLH) rules for smaller banks. The minimum requirement under the LCR is 100% (HQLA/net cash outflows), however all LCR banks are currently well above 120%, while MLH banks are required to hold liquid assets in excess of 9% of total assets. It should also be noted that the bulk of deposits at domestic MLH institutions are retail (i.e. sticky) providing a strong starting base in liquidity terms.” (WBC). Liquidity requirements for US banks are applied according to the size of the bank. Only banks with asset bases >US$750bn are required to meet the kind of LCR requirements that all Australian banks are required to meet. SVB was ranked 18th by total assets, but accounted for <1% of system assets. Regulatory wise, it slipped under certain minimums for wholesale funding, and were not subject to LCR or NSFR requirements. Australian banks on the other hand must hold minimum HQLA, or “High Quality Liquid Assets”, in order to meet minimum LCR’s. Australian banks are subject to one of the most conservative interpretations of the LCR regulatory requirement. They can only hold cash, ACGB’s and Semi’s as HQLA’s, and at the moment cash is elevated, which is evidenced by elevated ES balances – i.e., very liquid. US banks on the other hand have a broader range of assets they can hold for liquidity purposes, including investment grade credit or equity for some banks….and only for those banks big enough to fall within the regulators net. SVB was undone by the lack of interest rate hedging, which is not standard practice (not having it that is) and underpins my earlier accusations of gross incompetence. One key difference in capital requirementsbetween Australian and other jurisdictions, including the US, is the treatment of interest rate risk hedging. “Australian regulators have included IRRBB as a Pillar 1 requirement, with a capital charge reflecting risk. In other jurisdictions this risk is largely a Pillar 3 disclosure requirements, with the potential for a supervisory add-on to capital if required by the regulator. As a result, domestic banks offer strong disclosure, active risk management and a capital charge in place for this risk.” (WBC). In addition to LCR requirements, Australian banks are required to maintain contingent liquidity in the form of self-securitised assets, with a cash value equivalent to at least 30% (onto the LCR). The collateral needs to be needs to be unencumbered, and not held as collateral for any other purpose. So, no liquidity issues here. Not all AT1 is created equal…some are more equal than others UBS acquired Credit Suisse for CHF3bn (US$3.3bn) at the insistence of the Swiss National Bank. Credit Suisse equity holders received UBS stock in return, albeit at a deeply discounted price. Credit Suisse’ “alternative tier 1” capital was wiped out. Swiss authorities said those security holders would receive absolutely nothing, a move that is at odds with the usual hierarchy of losses when a bank fails, with shareholders typically the last in line for any kind of payout. Heads were being scratched. As a result of this very surprising, some might say, shocking turn of events, central banks and regulators around the world, including the BOE and ECB, released statements saying that common equity will be the first to absorb losses, and only after this will AT1 and Tier 2 securities incur potential losses in a non-viability situation. Where does that leave A$ AT1? Local AT1 securities have worn some pain as holders shoot first (sell) and ask questions later. Looking at the non-viability and credit hierarchy, under APRA guidelines the definition of non-viability is broad, effectively being triggered when APRA decides either i) conversion or write-off of capital instruments is necessary because, without it, the ADI would become non-viable; or, ii) without a public sector injection of capital, or equivalent support, the ADI would become non-viable. Conversion….”AT1 and Tier 2 instruments must contain a provision that requires the conversion to equity in a non-viability event, resulting in the dilution of equity holders. Write-off will only occur where conversion to equity is not possible (this includes some unlisted issuers). Australian instruments also allow for partial conversion, which was not possible in the case of CS.” (WBC) Importantly for tier 2 investors also, ranking rules dictate that APRA… “must provide for all AT1 capital instruments to be fully converted or written-off before any Tier 2 instruments are required to be converted or written-off. Any conversion or write-off of Tier 2 instruments will only be necessary to the extent that conversion or write-off of AT1 was required, and deemed insufficient for recapitalisation.” (WBC) Market reactions… Concerns the world was hurtling toward another financial crisis triggered a flight to quality in the past week or so. Bonds yields plunged and risk assets were abandoned with varying degrees of severity and indifference. Inflation risk was consigned to the back seat with a growing belief the Fed, ECB, RBA et al would be forced to halt their rate hike activities in order to preserve financial stability. The ECB, then the Fed has subsequently proven these beliefs to be wrong, for now. The longer run concern now is with rate hikes continuing, and potential credit rationing following banking turmoil, one or more central banks will fall off the narrow path between containing inflation and supporting growth. Plunging yields suggest rate cuts are on the way. Three-year ACGB yields fell -82 bps to 2.818% while the SVB and then CS saga played out. Market implied terminal cash rate pricing went from pricing in two more hikes to pricing a pause, followed to cuts in coming months. The ASX 200 lost ground, down -6.50% over the period in question (vs -4.75% for the S&P 500), while major bank AT1 lost -4.00% - 5.00% in local markets, and as much as -10.0% in US markets. Bank credit spreads widened, +15 bps at their worst, with 5Y indicative spreads rising from +91 bps to +106 bps (green line in the first chart overleaf). As I type, major bank senior spreads are back around +98 - 99 bps vs a long run average of +95 bps. Tier 2 spreads have been modest in the grand scheme of things, around +15 bps wider, possible +20 bps to +225 bps for 2028 callable paper. It is worth noting the relative stability and resilience of A$ bank spreads, and A$ credit spreads in general. Not just through the recent hiccup, but other incidences of market dysfunction also – A$ spread performance is adhering to the historical play book. The SVB situation came to a head on March 8th (when they announced a capital raising and sold long-dated government bonds at a heavy loss). For the sake of this exercise, we’ll look at month to date performance, just because. US and EU financial spreads are +40 bps and +30 bps wider MTD, which is a 30% to 40% move. At their peak, US and EU financial spreads were around +55 bps wider in each. A$ financial spreads are +3 bps or +4 bps wider over the same period, or around 3% to 4%, peaking at +6 bps to +9 bps. We expect A$ spread resilience to persist, and while the US banking sector remains somewhat in a state of flux, we feel regulators have done enough now to prevent a further meaningful sell off in spreads – beyond the wides already seen at least. This document is intended to provide general advice and information only and has been prepared by Mutual Limited (“Mutual”) ABN 42 010 338 324, AFS license number 230347 without taking into account any particular person's objectives, financial situation or needs. Investors should, before acting on this general advice and information, consider the appropriateness of this general advice and information having regard to their personal objectives, financial situation and needs. Investors may wish to consider the appropriateness of the general advice and information themselves or seek the help of an adviser. Mutual makes no guarantee, warranty or representation as to the accuracy or completeness of the general advice and information contained in this document, and you should not rely on it. The financial products referred to in this flyer are interests in the registered managed investment scheme known as MIF, ARSN 162 978 181 (“product”). Mutual is the Responsible Entity and issuer of the product. Investments can go up and down in value. Forecasts and projections are based on assumptions and information and reflect the reasonable expectations of Mutual available at the time. Actual results may be materially affected by changes in economic, taxation and other circumstances. The factors that could cause actual results to differ materially from the projections include, among other things, changes in interest rates, changes in general economic conditions Past performance is not a reliable indicator of future performance.

“There is a degree of caution as the RBA moves too hard, too fast” Mutual Limited CIO Scott Rundell answers the top questions financial advisers are likely to receive from clients concerned about interest rates rises. As the RBA hikes rates, Bank Bill Swap Rates (BBSW, a reference rate) move higher, often ahead of the RBA moves. All securities held in Mutual’s funds (except the Mutual Cash and Term Deposit Fund - MCTDF) are floating rate notes, whose coupons are set as a fixed margin to BBSW and every 30 days or 90 days, their coupons are reset. So, if the RBA is hiking, and BBSW is hiking, the coupon and running yield of Mutual’s funds generally go up with it. With MCTDF, the term deposits are closely aligned to BBSW, and can be expected to increase as well.

Global inflation is running hot and Australian households have not been spared the pain. As at the end of December, consumer prices (‘CPI’) had risen +7.8% over the year, more than double the growth rate from a year earlier (+3.5% YoY), and well north of the RBA’s target range (+2.0% - 3.0% YoY). Economic reality is such that inflation is bad, accept it. In order to contain inflation, the RBA has hiked the official cash by +325 bps from 0.10% in April last year, to 3.35% at the February meeting. This represents the most aggressive rate hike cycle on record, and as Tim Shaw would say, “But wait, there’s more.” At its last meeting the RBA signalled the need to raise rates a “couple” more times to combat inflation, which is generally assumed to be two more +25 bp hikes at a minimum, which would take the cash rate to 3.85% (base case). Subject to how the data plays out, there is risk of rates going higher again, potentially reaching 4.10% or even 4.35% as the absolute worst-case scenario. The surge in inflation has been driven by various factors, although three core reasons are generally accepted as the main drivers. First, supply chain disruption in the face of surging demand post the pandemic. Second, many advanced economies made a stronger-than-expected recovery from the pandemic thanks to an abundance of fiscal stimulus (i.e. JobKeeper payments) and extraordinarily loose monetary polices (i.e. very low interest rates). And third, commodity prices have risen sharply, which was exacerbated by Russia’s invasion of Ukraine. Most of these inflationary influences would normally be considered temporary. However, there is risk that with tight labour markets, wages will increase to compensate for higher prices, which could trigger a ‘wages-price spiral’. This could in turn entrench inflationary expectations, keeping prices elevated, and in turn keeping interest rates higher for longer. The Australian Wages Price Index (‘WPI’) published earlier today, indicating that wages for local workers have risen +3.3% YoY to the end of December, a ten-year high and up from the +2.8% YoY a year earlier and higher than the long run average of +3.1% YoY (1998 – now). With the RBA in the midst of an arm wrestle with inflation, upwardly trending wage growth is an area of focus and concern for the central bank. Historically, growth in the WPI has exceeded the prevailing CPI growth rate more often than not, which could arguably be put down to productivity gains given inflation over time has typically been trending lower, or at least within target ranges. Wage inflation without productivity gains is a concern, which is the risk we’re seeing now. With CPI running at +7.8% YoY, well outside the RBA’s +2.0% - 3.0% target range, the central bank is sweating moderate sized bullets that wages growth could get out of hand and spark a ‘wage-price spiral’. This remains a contributing factor to the RBA’s continued hawkish rhetoric on monetary policy settings and will keep the cash rate trending higher for at least another 2 – 3 months. Further, we do not expect the RBA will pivot on a dime and begin cutting rates any time soon. The ‘higher for longer’ narrative persists. Where does one park their ‘defensive’ capital allocation during such times? As a firm, we’re a strong believer in floating rate notes, which largely immunises investors against interest rate risk vs say a fixed rate bond. Monetary policy rhetoric remains hawkish, and it’s hard to argue against the likelihood of higher interest rate over the near to medium term. Since the RBA kicked off the current rate hike cycle (April 2022), fixed rate bonds have lost between -2.80% and -3.33% across Australian Government Bonds and State Government Bonds (Bloomberg AusBond Indices). The fixed rate credit index has lost -0.61%. Over the same period, Mutual Limited’s various retail funds have delivered returns of +2.18% for the Mutual Income Fund, +3.08% for the Mutual Credit Fund, and +5.51% for the Mutual High Yield Fund. Based on market pricing for forward cash rates and expectations around credit spread trends, these funds are expected to return +5.90% YoY, +6.60% YoY, and +9.40% respectively for calendar 2023. This document is intended to provide general advice and information only and has been prepared by Mutual Limited (“Mutual”) ABN 42 010 338 324, AFS license number 230347 without taking into account any particular person's objectives, financial situation or needs. Investors should, before acting on this general advice and information, consider the appropriateness of this general advice and information having regard to their personal objectives, financial situation and needs. Investors may wish to consider the appropriateness of the general advice and information themselves or seek the help of an adviser. Mutual makes no guarantee, warranty or representation as to the accuracy or completeness of the general advice and information contained in this document, and you should not rely on it. The financial products referred to in this flyer are interests in the registered managed investment scheme known as MIF, ARSN 162 978 181 (“product”). Mutual is the Responsible Entity and issuer of the product. Investments can go up and down in value. Forecasts and projections are based on assumptions and information and reflect the reasonable expectations of Mutual available at the time. Actual results may be materially affected by changes in economic, taxation and other circumstances. The factors that could cause actual results to differ materially from the projections include, among other things, changes in interest rates, changes in general economic conditions Past performance is not a reliable indicator of future performance.

“This is the most aggressive rate hike cycle in history” Mutual Limited CIO Scott Rundell answers the top questions financial advisers are likely to receive from clients concerned about interest rates rises, such as how investments may be impacted and where to from here? Scott also discusses why Mutual Limited Funds may be well positioned in this environment.

We break down the basics of fixed income markets Fixed income investing Fixed income assets can play a useful role in an investment portfolio. As the name implies, these assets provide you with regular income payments. What’s more, they can also bring diversification to a portfolio that’s overweight in investments such as shares and property. As with any investment opportunity, not all fixed income assets or the strategies for using them are alike. Here, we break down the fundamental attributes of fixed income assets and some of the ways they are used by investors. The fundamentals Fixed income is an umbrella term describing investments that make regular contractual payments to investors over the asset’s lifetime and then return the capital at call or maturity. The term is most commonly applied to government, bank and corporate bonds. Bonds are sold (issued) by governments, banks and corporations to raise capital and they operate like a loan. Issuers receive capital from investors and agree to pay regular interest over a pre-determined timeframe and pay back the capital when the bond matures. Fixed income can be floating The amount paid in interest can be fixed or floating. This payment is known as the ‘coupon rate’. Fixed coupons will not vary however floating coupons will adjust with underlying cash rates. Both are paid as a percentage of the principal balance and paid at regular intervals, 6 monthly for fixed, quarterly for floating rate. Payments are made until the bond is called or matured, typically 5 years, at which point the bond’s owner is paid its face value. Bond issuers are contractually obliged to make these regular payments. And because a bond is a loan, bond investors will be paid before shareholders receive dividends or if the corporation is liquidated. Buying and selling bonds Bonds can be bought on the: Primary market from the corporation or government that issues it, or Secondary market from a bold holder on the open market. Once a bond is issued, the interest rate for fixed bonds and the coupon spread for floating bonds stays the same. So if interest rates increase existing fixed bonds will become less attractive to investors and the capital price will decrease. Floating bond coupons will increase by nature of being floating and the capital price will be more stable. Visa versa in a decreasing interest rate environment. Want to learn more? Talk to Mutual Limited about how fixed income can deliver income and diversification to your investment portfolio.

With interest rates rising, fixed rate bonds – those with a set coupon rate until maturity - may be in for a tough time. That’s because rising interest rates reduce the price of fixed rate bonds. That may sound counter-intuitive, but its all to do with the change in a bond’s yield when interest rates change. It works like a chain reaction: higher interest rates reduce the demand for buyers of bonds, because higher returns are now available elsewhere. The price of that bond falls, increasing its yield. But a higher yield is a good thing, isn’t it? Unfortunately, not. The falling price is the major impact, rather than a higher yield. That’s because a yield is just a theoretical measure – it is not received every three months like a coupon. The coupon that the investor receives, meanwhile stays unchanged. For investors seeking to retain the safety of bond type investments but wanting to help shield again the negative impact of rising interest rates on the capital value of bonds, floating rate notes may prove to be a viable alternative. What is a floating rate note? A floating rate note (FRN) is a type of security that is commonly used by banks to fund their lending activities to mainly households or small businesses. FRNs are a debt obligation like a typical bond. Both represent a contractual requirement for the banks to pay the coupon when they fall due as well as the balance at maturity. In Australia most banks issue FRNs in the 3 to 5 year maturity. With a FRN, the coupon is floating. Every 90 days the coupon resets at a margin above the Bank Bill Swap Rate (BBSW). In a rising interest rate environment like we have at the moment, the BBSW is rising because it is effectively pegged to the official cash rate. From one coupon reset to the next, we see the coupons on these bonds rise by a fixed margin to that BBSW rate. Why do FRN’s have minimal interest rate risk? A floating coupon rate acts like a stabilizer to take away much of a bond’s duration risk. Duration risk is what adds volatility to a fixed rate bond. The coupon on fixed rate bonds is fixed, and therefore does not change from one payment to the next. It can’t change its coupon rate to act as a stabilizer. But what does change is the market demand for that bond, which also changes the underlying yield. How does this happen? When the yield of a bond increases above its coupon, typically the bond falls into a discount. For example, if a bond is issued at ‘PAR’ of $100, it may reprice at $97 due to lower demand from the duration impact (from an increase in interest rates). Because a floating rate does not have duration risk like a fixed bond, it the FRN’s price rarely moves far away from its PAR level. For example, its PAR may range between $99 to $101, while its coupon may increase as it approaches maturity. The underlying risk of a FRN, outside of duration risk, is generally the same as the fixed rate bond. Both foxed and floating rate bonds represent contractual obligations from the issuer, so their coupons must be paid to investors before equity investors receive their dividends.

The RBA has ratcheted up rates again for the third time in as many months. What does this mean for investors and financial advisers managing client portfolios? Scott Rundell, Chief Investment Officer of Mutual Limited (a fixed income fund manager distributed by Copia), answers four questions about the rate rise and its impact.