In this Stockhead feature, bond market expert Matthew Macreadie — Director of Credit Strategy at Income Asset Management — highlights three bond trades set to outperform in a changing rates environment.

Fixed-income investors expect to be tested further in 2022 as the beginning of a rising interest rate cycle looms. However, solid corporate earnings from the last financial year and a robust forecast economic rebound should ensure an ongoing pipeline of opportunities.

Relative calmness in credit spreads has been a key feature of the market in 2021.

Particularly — in contrast to the volatility in interest rates (and to a lesser extent equity markets), the credit environment has been relatively benign.

This has provided an opportunity for investors to generate good returns.

The Australian bond market’s lower technology exposure and higher exposure to cyclical, resource, financials, and insurance sectors, in a rising interest rate cycle should provide a degree of protection relative to the US bond market.

Furthermore, resource names like Pembroke are benefitting from the recent weakness in the AUDUSD, commodity price resilience (metallurgical coal prices) and an increase in government spending.

IAM has reviewed the pipeline of opportunities and have compiled their top 3 bond trades below.

1. QBE 2036s (Call in 2026) bonds – S&P: NA, Moody’s: Baa1

We like insurers, especially in an environment of higher inflation and interest rate hikes and believe the sector should be a pivotal part of an investor’s bond portfolio.

An increase in interest rates will benefit sectors which invest in government bonds.

Insurers tend to invest their cash into government bonds or relatively liquid securities which perform better in higher interest rate environments.

Furthermore, insurers tend to have inelastic demand profiles and so can appropriately deal with higher inflation.

QBE reported excellent HY22 results, showing a strong return to profitability and increased its HY22 dividend as a result.

The favourable global insurance pricing cycle is a major tailwind for QBE earnings, with the insurer likely to outperform market expectations in FY22 alongside continued reserve strengthening.

The QBE 2036s (call in 2026) bonds offer a yield to call (YTC) of mid 3% for investment-grade risk.

2. Ausnet Hybrids (Call in 2025) – S&P: BBB-, Moody’s: Baa3

Post takeover by Brookfield, Ausnet is arguably in a stronger position for the long term with its current ownership base.

Ausnet has three distinct regulated businesses which provide stable cashflows and have very little volatility.

In a higher inflation environment, these regulated businesses act as an inflation hedge given their strong pricing power.

Ausnet also has mostly fixed-rate debt in place and have used the last few years to term out their debt. This is positive in a rising interest rate and thus cost of debt environment.

The Ausnet Hybrids (call in 2025) offer a yield to call (YTC) of mid 4% for investment-grade risk.

3. Pembroke 10% (Call in 2025) – Unrated

Resource credits tend to benefit from acting as an inflation hedge, and Pembroke has one of the largest steelmaking coking coal reserves in the world.

The metallurgical coal project is underpinned by strong backers with all construction permits and mining leases in place.

Bondholders also benefit from a substantial covenant package, with amortisation commencing after 33 months (average life of 5.75 years).

We like the participation via Northern Australia Infrastructure Facility (NAIF) and the Queensland state government which lends conviction and credibility towards the project.

While China still has an official ban on Australian coal imports, Chinese steel demand is expected to pick up after the Winter Olympics (4-20 February) given the PBoC explicit easing bias and pro-growth stance.

Strong Chinese demand for coking coal will eventually translate through to strong demand for Australian coal from the ex-China market.

The Pembroke senior secured bonds (Call in 2025) offer a yield to call (YTC) of close to 12%.

In terms of portfolio construction, to get the benefits from the lower-end of the high-yield spectrum, we would advise investors to ensure they have appropriate diversification in their bond portfolio.

This article was developed in collaboration with Income Asset Management, a Stockhead advertiser at the time of publishing.
This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.