Australian market commentary
The Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) returned 0.31% over the month. The yield curve was largely unchanged as 3-year government bond yields ended the month 1 basis point (bp) lower at 0.25% while 10-year government bond yields fell 2 bps to 0.87%. Short-term bank bill rates were mostly steady. The 1-month rate was unchanged at 0.09%, the 3-month rate was also unchanged at 0.10% while the 6-month rate was 1 bp lower at 0.16%. The Australian dollar rose, closing the month at USD 0.68.
The Reserve Bank of Australia (RBA) held the cash rate steady at 0.25% in June and maintained the 3-year bond yield target of 0.25%. The domestic government bond market is working effectively and the RBA has scaled back the size and frequency of bond purchases after initially purchasing around AUD 50 billion in bonds. The RBA has retained its commitment to scale up buying again if needed, and to keep funding costs low and maintain credit availability to households and businesses. Term Funding Facility use has reached AUD 6 billion, with further usage expected in coming months.
Domestic economic data releases were weaker in June. The effects of COVID-19 continue to show through the data. Employment fell by 227,700 positions in May, larger than the expected 78,600. The unemployment rate in May continued its rise to 7.1%. Q1 GDP was negative at -0.3%. The NAB Survey of Business Conditions did rebound in May however remained deeply negative at -23.8 points, with business confidence similarly rebounding but remained weak at -20.0. Retail sales through April were down 17.7%. National CoreLogic dwelling prices continued to fall in June printing down 0.4%.
Australian market outlook
The outlook for both the Australian and global economies continues to be clouded by the COVID-19 crisis. There remains little doubt that the world is heading into a recession given the various levels of industry and workplace shutdowns. In Australia, the RBA is forecasting a fall in GDP in the first half of 2020 of approximately 10%, albeit with a strong rebound in 2021.
The Australian government has introduced unprecedented stimulus measures to overcome the crisis, and questions remain over what happens when these initiatives end, which is quickly approaching as the original programs were slated to run for only six months. Many countries across the globe will be running deficits of over 10% of GDP. The Australian government is no different and will need to fund large levels of debt issuance this year.
The RBA’s quantitative easing (QE) has been designed to make financing conditions easier and to give banks an incentive to make sure the money gets to where it is needed most. According to the Australian Banking Association, there have been deferrals on over 485,000 mortgages and more than 215,000 business loans, together totalling AUD 236 billion of deferred loans. The RBA’s quick actions to make funding cheaper should help the banks alleviate some of this pain, but profitability across the economy is set to be weak and many of those borrowers could become distressed should the deferrals end.
Locally, the lockdowns have eased across most states with many businesses now allowed to re-open, albeit with limited capacity in order to maintain social distancing. The retail and hospitality sector have taken the largest hit, and with international travel still banned and some state borders still closed, it will take a long time for businesses in the sector to recover. The stresses on small business will be large and the economic outcome is still uncertain. More recently, a surge in community transmission of COVID-19 cases in Victoria has seen localised lockdowns introduced. While Australia had seemed set to avoid a “second wave”, this setback is a timely reminder to all of how fragile the situation remains.
Credit commentary
Credit markets in June continued the reversal of March’s losses. The physical market in Australia tightened about 16 bps to government bonds by the month’s end. Unlike the last two months where most tightening was in major bank paper, the tightening was across most corporate bonds. Major banks are now marked at spreads tighter than the pre-COVID-19 period. Both domestically and offshore, synthetic markets credit spreads narrowed, the US CDX slightly by 2 bps, the European iTraxx by 7 bps and the Australian iTraxx by 14 bps.
Rating actions were more subdued than any month since the pandemic extended beyond China as the agencies fine tune their actions of the past few months. Australia had its Aaa rating affirmed by Moody’s with a stable outlook, contrasting with the negative outlooks from Standard & Poor’s (S&P) and Fitch. The University of Technology Sydney had its Moody’s Aa1 rating affirmed but with the outlook revised to negative from stable by Moody’s, due to low cash buffers coupled with heightened uncertainty with respect to student enrolments. AMP Ltd and its subsidiaries AMP Group Holdings Ltd and AMP Bank Ltd had their BBB+ ratings placed on credit watch negative by S&P, reflecting an expectation that the sale of the Life company is now imminent.
S&P downgraded Melbourne Airport to BBB+ from A- and affirmed the ratings of Adelaide Airport, Brisbane Airport, Perth Airport and Sydney Airport, moving them from negative watch to negative outlook. S&P also affirmed Auckland International Airport and removed it from negative watch, placing it on a stable outlook.
Crown Resorts Ltd had its BBB ratings affirmed by S&P and the rating was removed from CreditWatch Negative, with the outlook now negative. Ampol Ltd (formerly Caltex) had its Baa1 ratings affirmed by Moody’s after Alimentation Couche-Tard did not proceed with an acquisition due to uncertainty caused by COVID-19.
Deutsche Bahn AG was downgraded to AA- from AA and kept on negative outlook by S&P due to the impacted of COVID-19 related disruptions on passenger volumes. Moody’s affirmed the ratings of Daimler AG and Volkswagen AG to negative by Moody’s, from review, and the company’s A3 ratings were affirmed. Volkswagen Financial Services AG had its A3 ratings affirmed by Moody’s. The outlook is negative.
S&P released its latest fallen angels report. (Fallen angels are issuers downgraded from investment grade to sub-investment grade.) The list included an additional six fallen angels in June bringing the 2020 total to 30. Beyond that, a record 126 entities are now “potential fallen angels” having ratings of BBB- and negative outlook or watch. The 30 fallen angels represent over USD 300 billion of debt, with the largest five (Ford, Occidental, Kraft Heinz, Atlantia and Apache) contributing nearly three quarters of that amount.
In securitisation news, S&P released its SPIN data (mortgage arrears) for April 2020 with a slight overall increase: 30+ day arrears increasing 8 bps to 1.11% while 90+ day arrears increased 2 bps to 0.51%.
There were six corporate issues in June totalling just over AUD 5.1 billion with non-financials also contributing just under AUD 1.86 billion from Brisbane Airport, Optus and Westlink Motorway Group. Financial issuance was predominantly offshore from SMBC and CIBC. Issuance in securitised markets was reasonably strong at AUD 2.7 billion over five transactions all from non-ADIs; one prime RMBS from Triton (Columbus Capital), three non-conforming RMBS from Pepper, Liberty and Sapphire (Bluestone) and one SME CMBS from RedZed. The AOFM invested about AUD 588 million in secondary switches in June and invested in tranches of the Liberty and RedZed deals. The AOFM also invested AUD 456 million into six securitisation warehouses.
Credit outlook
The term and response to the virus remain the core determinants of the outlook. After a contraction of spreads in the last three months, credit still offers some value but is far less compelling than in March. On the current environment of uncertainty and nervousness, caution becomes the key requirement. The number of fallen angels, as mentioned earlier, highlight the heightened challenges during this period. Understanding of the different risks involved in individual credit issuers has become increasingly pertinent as the initial spread widening becomes increasingly refined depending upon the characteristics of the issuers.
Supply and demand in January and February were strong but disappeared in March and April, reviving to a degree in the last two months. Going forward until markets settle and outcomes from virus-related restrictions become clearer, it would seem likely that supply—especially in the non-financial corporates—will be patchy. Domestic non-financial supply is traditionally less abundant and is being tempted to offshore markets where government buying of credit has strengthened both demand and pricing of credit.
Any allocation to credit should be more weighted towards shorter dated credit which is less sensitive to spread movements, in our view. Given that non-financial corporate spreads are still relatively wide in Australia compared to offshore, financials are expected to remain the most common issuers in the Australian market and can offer value even in the current environment. However, for offshore issuers, caution must be applied both due to the long running issue of the complexity of the variations in treatment of capital requirements with varying rules on TLAC (total loss-absorbing capacity) and due also to the different levels of impact of COVID-19 in the markets.
Accordingly, domestic major banks offer a simpler value proposition due to their liquidity—although the sovereign’s Term Funding Facility, which provides cheap funding to Approved Deposit Institutions, may limit the availability of securities and recent spread contraction makes them appear expensive—while some of the smaller local ADIs provide a solid spread with conservative management. On the non-financial side, airports and airlines are the most obvious sectors to avoid but even the less-immediately-exposed issuers must be scrutinised very carefully for indirect impact from the expected economic downturn. Securitised products would appear to be a potential area of value, but even with these a thorough examination of structure and assets is necessary.
