The Australian bond market just had its best third-quarter performance since 2011 and the strongest start to a year since 2020. But while investors may be eagerly anticipating a rate cut from the Reserve Bank of Australia (RBA), playing the waiting game can be a risky strategy.
Timing the stock market is hard but timing the bond market is not a walk in the park either. While inflation is moving in the right direction in Australia, the last mile is sometimes the trickiest, with the annual trimmed mean inflation figure of 3.5% still sitting outside the RBA’s preferred target band of 2-3%. The RBA’s relatively hawkish stance has kept Australian bond yields higher compared to global markets, making this a potentially opportunistic time for investors to deploy capital into income-generating fixed income securities, such as Australian banking credit.
Moving away from the all-important upcoming RBA rate decisions, recent Australian fixed income news has also been focused on the Australian Prudential Regulation Authority’s (APRA) announcement to gradually phase out hybrid securities. Set to begin in 2027 and conclude by 2032, this phase-out will require banks to replace their hybrid capital requirement through both subordinated bonds and common equity. APRA’s primary concern and rationale for this decision is centred around the complexity of hybrid securities, especially for retail investors who may not fully understand the risks. While eliminating hybrids in its entirety is surprising, this shift highlights the importance of diversification within fixed income portfolios. Relying heavily on a single type of security can expose investors to heightened risks, particularly when regulatory changes impact that security type. If the proposal does materialise, as the market transitions away from hybrids, investors may find value in spreading their exposure across various fixed income securities.
Despite the regulatory distraction, fixed income is still front of mind for investors. The equity risk premium has fallen in recent years as bond yields have risen in the face of rising inflation. This has meant that the “income” is now back in “fixed income” with some senior ranking bonds from leading Australian banks now yielding more than the companies’ equity dividend yield. This shift prompts an important question: should investors move out of banking shares and into banking credit? While banking bonds offer appealing yields with typically lower risk than shares, both serve distinct roles in a portfolio. Bank shares may offer growth potential, benefiting from capital appreciation and dividends. Banking credit, meanwhile, provides steady income with defensive qualities, potentially buffering against equity market volatility. By holding both, investors capture the stability of bonds and the growth opportunities of equities, creating a diversified exposure. This balanced approach can potentially increase the resilience of investment portfolios and help smooth out returns over longer-term cycles.
Also read: Managing Credit’s Pricing of Perfection
Heading into 2025, fixed income investors may need to monitor several factors at play. A key focus is the uncertain path of interest rates. While markets anticipate possible rate cuts from the RBA by early to mid-2025, this is far from guaranteed, particularly if inflation proves to be “sticky” and remains elevated. The RBA also has less room to cut relative to our developed market peers who began their rate hiking cycle earlier and went further than Australia. This uncertainty around rate decisions makes it prudent to stay flexible with bond allocations, particularly by incorporating instruments like floating rate notes, which pay interest that adjusts with benchmark rates, which can help reduce sensitivity to rate changes, offering some layer of protection if rates move up unexpectedly.
Another factor to watch closely is the credit spread environment. Credit spreads are the difference in yield between a risk-free bond (like an Australian government bond) and a bond with credit risk (such as those issued by corporations). It measures the extra return investors require to compensate for the risk of default associated with the issuer. Currently, credit spreads are quite narrow, reflecting low compensation for credit risk. However, if a risk-off sentiment re-emerges, perhaps due to economic slowdowns or geopolitical concerns, credit spreads could widen, potentially impacting fixed income returns. Investors may want to ensure that they maintain a quality approach to their fixed income allocations and consider issuers of superior credit quality as part of their broader portfolio strategy. For example, Australian banks are leading in terms of their capital adequacy ratios and are ranked as one of the least risky among other peers according to S&P Banking Industry Country Risk Assessment (BICRA) scores.
With term deposit rates declining in recent months and ongoing uncertainty around interest rates, alongside Australia’s higher rate differential compared to some global peers, now may be an opportune time for investors to consider Australian banking credit. Investing across the capital structure such as senior bonds, subordinated bonds and hybrid securities can provide a diversified source of income. Rather than selecting individual banking credit securities and managing the complexities of maturity roll-offs, an exchange-traded fund (ETF) offers a streamlined and diversified approach.
The Global X Australian Banking Credit ETF (BANK) provides a low-cost way to access a broad range of Australian banking debt in a single, transparent and tax-efficient structure that trades on the share market. BANK invests in a diverse portfolio across the capital structure, including fixed and floating-rate bonds, senior and subordinated debt, and hybrid securities from APRA-regulated banks. With a current running yield of ~6%, access to reliable income from stable financial institutions could be especially attractive to investors as they look ahead to 2025.
