With the prospect of interest rate cuts on the horizon, bonds are expected to perform relatively well in 2024, offering investors income and the opportunity for capital gain, according to Matthew Macreadie, executive director of credit strategy and portfolio management at Income Asset Management.
Mr Macreadie is recommending investors buy Australian Tier 2 bank and insurance bonds.
“2024 promises to be a year of clear winners and losers where security selection will be rewarded. We expect to see some high yield defaults impact the market, but overall, the investment-grade credit market is likely to gain in strength,” Mr Macreadie says.
“With inflation falling from its multi-decade highs, and the prospect of modest rate cuts in the second half of 2024, we should see longer duration, high quality bonds perform well and gain in value. Beyond 2024, interest rates could fall further as central banks, having likely tamed inflation, reduce interest rates to protect employment and economic growth, supporting the environment for bonds,” he says.
With bond yields at their highest levels for several decades, Mr Macreadie also believes Australian investment grade bonds could outperform against US bonds and provide a good buffer against any potential credit spread widening.
“Australian credit spreads usually follow credit spreads in the US, but we believe they could outperform in a recessionary scenario. That's because Australia’s real economic growth supports the credit environment and Australian investment-grade credit has historical default rates close to zero.
“In addition, Australian superannuation funds have been increasing their exposure to fixed income - and Australian BBB investment-grade credit spreads are wider than equivalent US investment-grade credit spreads - so we are confident of the potential for the outperformance of high-grade Australian corporate bonds," he says.
Within the Australian investment grade credit market, IAM believes some sectors could outperform. Tier 2 bank and insurance bonds, for example, are offering “outsized risk-adjusted returns”.
"Australian banks are well positioned for any downside in the economic outlook. They are well capitalised, with very high Common Equity Tier 1 capital ratios. The most positive development has been that Australian mortgage delinquencies have not really risen significantly despite central bank tightening,” he says.
“Residential mortgage-backed securities (RMBS) are also favoured, given credit spreads effectively doubled in 2022 and are only now starting to normalise across senior and mezzanine tranches. From our perspective, buying AA-BBB rated RMBS tranches at yields of 7 per cent to 9 per cent with strong collateral protection remains very attractive,” he said.
“We are constructive on most sectors within the Australian corporate market such as infrastructure, utilities, retail and mining, especially as issuance will remain muted in 2024. Additionally, Australian companies are running net leverage and interest coverage ratios in line with historical averages and have the capacity to absorb an economic shock.”
Mr Macreadie also sees healthily outcomes for private credit, which historically offered an illiquidity premium over the public bond market. In the higher yield environment, investors are looking at the merits of private credit as an alternative to equity given attractive yields.
"With current yields of around 5 per cent to 7 per cent in investment-grade credit, and 6.5 per cent to 10 per cent for sub-investment-grade credit, complemented by high-certainty cash yield and capital seniority, we expect strong investment demand for private credit in 2024," says Mr Macreadie.
One sector, however, that IAM is cautious on is A-REIT bonds. “We view significant potential for volatility during 2024 as the devaluation cycle plays out for office and retail sectors, so we could see rising vacancies compress values.”
