Australian Corporate Bonds Look Appetising

22 February 2022: The inflation debate has intensified in recent months.

Counter to the current bearish consensus on the fixed income market, Franklin Templeton’s Australia Fixed Income group has called out investment grade corporate bonds for their appealing total return prospects over the next one to two years.

Andrew Canobi, Director, Franklin Templeton Fixed Income, says: “What has caught our eye has been the slow repricing of high-quality investment grade corporate bonds over the last three months.”

Canobi is a portfolio manager forthe Franklin Australian Absolute Return Bond Fund. “Each of the three components of corporate bond pricing – government bond yields, swap spreads and credit spreads – all three layers of the cake, if you like, are attractive now,” he says.

The three-year government bond yield is sitting around 150 basis points above the Reserve Bank of Australia cash rate, implying a market expectation of almost 150 bps of interest rate hikes in the year ahead.

“If you believe this is overdone and highly unlikely to be realised, which is our view, government bonds are cheap,” Canobi says.

Swap spreads represent the difference between the yield on an interest rate swap and the government bond of like tenor. Across a range of maturities, spreads are currently close to the widest they have been in a year.

This is the return on offer for investors accepting credit risk, as opposed to the ‘risk free’ yields in the government market. Investment grade spreads as measured by the iTraxx Australia CDS index are close to their wides of the last 12 months.

Canobi says: “High government bond yields plus wide swap spreads plus wider credit spreads have all gone into the mix and are cooking up into a tasty layer cake.”

Australian utility and real estate bonds are trading at yields just under 3% for bonds with ratings in the single A or high BBB categories. Yields of around 3.5% are common for bonds with longer durations. Franklin Templeton’s focus is on the high quality, defensive names.

“Higher yields mean lower prices. These bonds with 3% yields are trading below their par prices of $100. The return on offer is the coupon income plus the ‘assured’ capital gain from buying a bond at, say, $95 and then seeing it return to its par price,” Canobi says.

“Corporate bonds could become ‘cheaper’ in the short term if their yields go higher. But total returns now look compelling.”

Canobi’s view is that government bond yields will decline as the air comes out of the rate expectations bubble, swap spreads will narrow back towards their long-term averages, and credit spreads will stay where they are.

He believes such an outcome would produce strong performance for the corporate bond sector over the next one to two years.

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