Rachel Shirley

Alexander Funds wishes to announce that Chief Executive Officer, Rachel Shirley has tendered her resignation. However, she will remain with the firm to facilitate an orderly transition.

As co-founder of the business and inaugural CEO, Ms Shirley has achieved the goals she set out to accomplish and believes the firm is well placed to continue its growth and success under new leadership.

“Upon establishment of the firm, my goal was to build a strong, respected, standalone organisation with the capability, culture and foundations to succeed well beyond its early years,” Ms Shirley said.

“Having delivered on the strategic priorities, I believe now is the right time to hand responsibility for the next phase to a new guardian of the business. This decision comes with deep gratitude to the team, both past and present, who have helped build this organisation. A special thank-you also to our investors and partners who have supported our vision.”

Trevor Chudleigh, Chair of the Board said, “Rachel has been fundamental to the growth and development of the business over the past 17 years, since its establishment in 2009 and we wish her well in her next chapter.”

The firm, its employees and clients will continue to benefit from her significant contribution, and we are grateful Rachel is remaining in her role to support the appointment of her successor and ensure a smooth transition.

Since its establishment in 2009, Alexander Funds has grown to approximately $1.6 billion in funds under management and continues to be a trusted, reliable and consistent performer in the fixed income credit markets.

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Oliver joins the Distribution team at Alexander Funds, led by Chris Inifer, Head of Distribution & Marketing. He will support the distribution team nationally and report into James Curnow, Regional Manager for NSW, ACT and QLD, who is also based in Sydney.

“Alexander Funds continues to experience strong growth through retail and wholesale adviser channels. Oliver’s appointment as Business Development Associate in our Sydney office will strengthen our ability to support and engage with our expanding client base,” said James.

Prior to joining Alexander Funds, Oliver worked at Royal Bank of Canada in Institutional Equity Sales. He previously held roles at PAC Partners in Institutional Equity Sales and at Bell Potter Securities, where he worked as an Associate in their Wholesale Financial Advisory and Broking team.

Oliver holds a Bachelor of Agricultural Economics from the University of Sydney.

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Beatriz Marchueta

Alexander Funds is excited to announce the appointment of Beatriz Marchueta as Regional Manager for VIC, SA & TAS, based in Melbourne.

Beatriz will join Head of Distribution, Chris Inifer, and will focus on adviser, family office and high net worth clients in VIC, SA and TAS. She will also work alongside James Curnow, Regional Manager NSW and QLD, who is based in Sydney. “Alexander Funds continues to grow strongly and Beatriz’s appointment to the Distribution team will allow for greater coverage of the growing support base” says Chris Inifer.

Prior to joining Alexander Funds, Beatriz worked at Millbrook Group as National Investment Adviser, responsible for managing a diverse range of portfolios and ensuring alignment with her clients’ needs. Prior to that, Beatriz held the role of Business Development Manager at La Trobe Financial.

Beatriz holds a Bachelor of Arts from Murdoch University.

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Giles Gunesekera

Alexander Funds, a Melbourne based boutique credit Investment Manager has great pleasure in announcing the appointment of Giles Gunesekera OAM as Independent Chair of the ESG Committee.

Giles will add independent, external expertise to Alexander Funds’ Committee and is tasked with ensuring Alexander Funds integrates industry best practices, regulatory developments, and evolving ESG standards in a pragmatic and considered manner across the organisation.

With expertise in ESG and impact assessment, Giles will contribute valuable insights into integrating sustainability considerations into the decision-making process at Alexander Funds. This approach aligns with the growing emphasis on responsible and ethical business practices. “In shaping the Committee’s composition, the executive has been focused on finding an independent Chairperson with specialised knowledge relevant to our business. We strive to be forward-thinking within the investment industry, and this ambition extends to ESG considerations” says CEO Rachel Shirley.

Giles is a leading executive across the fields of climate, health, housing, and sustainability, a 30-year asset management veteran and has received an Order of Australia for his outstanding work as a social welfare activist. Giles is the founder and CEO of Global Impact Initiative, an organisation focused on Impact Investing.

Giles previous roles include managing director and head of third-party sales at Principal Global Investors and State Manager for New South Wales and the ACT at Merrill Lynch Investment Managers.

Giles appointment follows Trevor Chudleigh’s appointment as Independent Chairman for the business late last year and strengthens the growth and development of the organisation.

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The advent of MPT brought a great deal of science and formal theory to portfolio construction.

Background

Since their inception, financial markets have provided investors with the opportunity to increase their wealth. However, this is of course not always the case – at times, and without warning, these markets see dramatic price declines or volatility, resulting in the significant decrease in investors’ wealth. These moves may be the result of a weakening economy, a systemic shock to a particular market, or the ending of a period of irrational enthusiasm by investors. Regardless of the driving force of these moves, investors must remain vigilant and well positioned to ensure that these periods of volatility do not cause permanent damage to their investment portfolio.

During the latter half of the 20^th century, significant advancements were made in the field of financial economics. These developments provide a superior framework for investors to manage and understand portfolio volatility and risks. One of the most significant developments was Harry Markowitz’s concept of Modern Portfolio Theory (MPT). A vital element of the theory was the formalising of an asset’s risk as the standard deviation of its returns, and in turn the formation of an efficient frontier of possible investments. This acknowledgement enabled investors to compare the risk-return profile of two assets and select the one with the highest return for a given risk, or the lowest risk for a targeted return. Another significant outcome of MPT was the recognition of how investors could achieve the optimal level of diversification within their portfolios.

While investors recognised the value of diversification prior to MPT, it was more of an art than a science, with successful portfolio managers relying on asset-picking and market timing. Both activities have proven all but impossible to implement successfully on a consistent basis across market cycles. Other investment strategies involved simple rules-of-thumb, such as 1/3 equities, 1/3 bonds and 1/3 real estate, or simply aiming to maximize returns.

Post MPT, new heuristics developed around the role of each asset class. Equities became known as the potentially higher returning assets, but with these returns came higher risk. Alternatively, the fixed income sector was seen as a source of lower but more stable returns. Therefore, an aggressive (conservative) investor would maintain a portfolio of 80% (60%) equities and 20% (40%) fixed income. Crucially, this high-level definition of fixed income investments did not discriminate between the various sub-classes within the fixed income universe. One class which is discussed later is credit assets.

The development of a formal asset pricing model was the next stage of evolution within the field of financial economics. The initial model, the Capital Asset Pricing Model (CAPM), divided risk into systemic risk (risk that cannot be avoided via diversification) and those risks particular to a given asset. From the CAPM came two significant metrics, the Sharpe ratio, and the information ratio (IR). The Sharpe ratio, developed by one of the originators of the CAPM model and Nobel Memorial Prize in Economic Sciences winner William Sharpe, became the accepted term for measuring risk-adjusted returns.

Equation 1 defines the Sharpe ratio, with:representing an assets or portfolio’s return minus the risk-free rate, defined as its excess return. To identify the excess return per unit of risk, the excess return is divided by the portfolio’s volatility, as measured by its standard deviation.

With the general acceptance of the Sharpe Ratio, the desire for additional metrics grew. One such example was the need for a metric to compare the variations of returns across, and within, asset classes.  The IR was adapted to assess these nuances. The key difference is that the risk-free rate is no longer included, replaced by the relevant benchmark for the portfolio. For instance, an Australian large cap manager would utilize the ASX200 as the benchmark, while a domestic credit manager may use a composite bond index.

While the Sharpe and Information Ratios have been widely adopted, they are not without fault. As seen in Equation 1, the denominator is the variance of a portfolio’s return, where these returns are assumed to be normally distributed. When returns display asymmetric results, the Sharpe ratio loses some of its relevance.

One point of difference between credit and equity securities is the risk of default. In this instance, default refers to an issuer of a given security not paying the legal coupon and/or returning the entire principal at maturity. In such an instance, the security is at a heightened risk of losing a considerable amount of its value. In comparison, a company is never obliged to continue dividend payments, nor to return any capital as shares exist in perpetuity. Therefore, a credit manager must manage market risk – that is the movement in credit spreads – and credit risk, which is the risk of default. In comparison, equity managers will look to manage the market risk of their securities as prices move in response to new public information.

Regarding the IR, the selection of a relevant benchmark is crucial. This choice is relatively straightforward for equity managers, but for fixed income managers the availability of an investable benchmark can be problematic. For example, a credit manager may invest across a broad range of securities, for example corporate bonds, private credit, structured assets, or distressed debt. All these assets have very different characteristics, meaning it is difficult to find a single relevant benchmark. Regardless of these issues, both ratios can make a meaningful contribution to the process of portfolio construction.

Australian case study

This section provides a brief practical example of how one might look to utilise MPT and associated metrics to construct an Australian domiciled investment portfolio. There will be a particular focus on the implications for assessing and selecting credit funds. The data also provided insights into the appropriateness of the two metrics across the various asset classes.

The figures and data used in this exercise are the 3 year (annualised) returns, associated standard deviation and relevant ratios sourced from the Morningstar Direct database for Australian diversified credit, and blended Australian mid/small and large capitalisation funds. Critically, this analysis is based solely on past returns and does not forecast future returns.

Figure 1 places the return profile of funds within the three fund categories in the classic risk/return space (returns on the Y-axis and risk/standard deviation on the X-axis). In general, the results are consistent with expectations that equity funds, on average, provide higher returns, but these come with greater risk (higher standard deviations). Additionally, within the equity space small/ mid-cap funds are riskier, with a large return variation within the peer group. Over the same period, credit funds delivered in general lower returns with lower risk, again consistent with the belief that credit funds will deliver relatively stable returns, at the cost of an uncapped upside.

Having identified an appropriate asset allocation, the next question is how to select the appropriate fund(s) for one’s portfolio. This analysis will mainly focus on the diversified credit segment. Prior to assessing the available credit funds, it is crucial to define the expectations around what one can expect from a credit fund. In general, a credit fund’s returns will predominately come from the yield of the securities within the portfolio. For an Australian fund, this yield will be greater than the official cash rate as set by the Reserve Bank of Australia (RBA).

The gap, known as the spread, primarily depends on the risk profile of the securities within a fund. The other source of return will be capital returns. This return fluctuates as the market price of credit securities fluctuates in a manner consistent with other risk assets. This capital return will also be affected if a particular security defaults or faces a ratings downgrade.

Returning to the expectations regarding a credit fund, it is most likely that investors will be after stable returns to offset the volatility stemming from the equity component of their portfolio. Therefore, the Sharpe ratio and IR are well placed to provide meaningful insights. From Figure 1, it is evident that there is a noticeable variation in risk and return for the 3-year numbers. Importantly, given the generally lower returns of credit funds, the effects of these variations become evident through an assessment of the Sharpe Ratios across the investment universe.

Figure 2 illustrates the variation in Sharpe Ratios across the three asset classes used in this paper. The first point that becomes apparent is that despite the variations in return and risk, the equity funds are quite tightly bunched. This position contrasts with the figures for the credit segment, where not only is there a broader spread but a noticeable proportion of the population returning a negative Sharpe ratio. The ramification of this characteristic is that managers were unable to outperform the cash rate, an outcome which is a red-flag when selecting any fund.

What are the implications of these findings? Credit funds offer compelling risk adjusted returns in comparison to equities. More importantly, the evidence suggests that investors need to carefully assess those funds to ensure they meet their investment objectives, which is primarily to provide a stable income flow with limited downside risk to the capital value of the investment.

What are the likely characteristics of a credit manager who can meet these requirements? At a minimum they are likely to be able to adjust the following attributes of their portfolio to meet the prevailing market conditions:

• Duration: A portfolio’s duration reflects how much the capital value of the portfolio will vary with a change in credit spreads. If spreads are expected to tighten (loosen) then a higher (lower) duration is appropriate. Therefore, a credit manager can underperform if they have extended their duration in the hope of improved market conditions, only for these conditions not to eventuate.
• Credit Risk: A credit manager can increase (decrease) their yield by going further down (up) the capital stack, as determined by a security’s credit rating. If a manager is anticipating benign conditions and increases their credit exposure, returns can be diminished because an issuer defaults on their payments or low rated securities de-rate further in a risk-off environment.

Figure 2 provides the data on the IR across the three selected asset classes. In contrast to the findings of assessing the Sharpe ratio, the results are far more informative for the equity funds than the credit funds. Informative in the sense that there is a greater variation in the results, which in turn enables investors to identify those funds which have outperformed on a risk adjusted basis. The data also provides an insight into the shortcomings of IR for assessing credit funds, that is the median IR is materially higher than those of the equity funds.

The origins of the contrasting IR results are seen in Equation 2. Utilising a benchmark as opposed to the risk-free rate allows one to identify the better performers within an asset class. This characteristic is particularly useful for equity funds where there is an obvious and, more importantly, investable benchmark. Indeed, from Figure 3 one can see that over 3 years the median large cap manager failed to better their benchmark, identifiable via a negative IR, indicating that an index fund may be a more appropriate investment. Alternatively, in the small/mid cap space the median manager has added value and there are several managers that have performed well.

Regarding the credit fund universe, there is not the dispersion of IRs within the sample. A partial explanation is that there simply is not the same quantum of opportunities to add (or destroy) excess value via a small number of positions that vary greatly from the benchmark – a common strategy for equity managers.  Compounding this point is the difficulty in establishing an effective benchmark because the credit markets are wide, with some sections lacking depth. However, the more relevant point relates to the purpose of a credit fund, which is to deliver lower but stable returns. Therefore, to identify the credit managers that have performed well the Sharpe ratio is more appropriate.

Conclusion

The advent of MPT brought a great deal of science and formal theory to portfolio construction. These developments allow investors to construct portfolios that meet their individual needs. However, there certainly is not a “one size fits all” approach, and it’s important to understand which ratio or approach is most appropriate for assessing their investment options. MPT has also allowed investors to clearly identify the role of each asset class within their portfolio and provides the ability to assess the risk-return characteristics of each class. As we’ve seen, credit funds were assessed as appropriate for investors seeking stable returns. This fact is not to say that excessive returns are not available in credit markets, rather to say that these sorts of returns are the exception. Another quandary for credit investors is to find an appropriate benchmark which offers a meaningful hurdle for managers to better. Therefore, assuming that past performance is no guarantee of future performance, the Sharpe ratio is the most appropriate way to compare the risk-adjusted returns of credit funds.

By Matthew Oldham, Head of Data Analytics and Chris Black, Co-Founder & Senior Portfolio Manager.

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What are the origins of private credit markets and the opportunities they present for investors?

Debt is a vital source of capital for all participants in the economy. The ability to access credit, thereby going into debt, allows actors to bring forward consumption and make investments, a process that bolsters economic growth. Of course, this statement only holds true if the debt is repaid, or at least refinanced, in full at some stage.

Figure 1 illustrates the net level of debt outstanding between the various entities in the Australian economy at the end of September 2023. Central to the creation of debt are financial corporations, such as banks, as they redirect excess capital from savers and investors to those seeking credit. In September 2023, the demand for credit in Australia, without considering the financial sector, was $90.2bn.^[1]

While credit is an essential element of the modern economy, there have been times when excess credit creation has led to an overheating economy. This subsequently leads to a slowing economy, placing borrowers under pressure and increasing defaults. The most recent example of this dynamic was the Global Financial Crisis (GFC).

As discussed in detail later in this article, over time global authorities have attempted to create policies that will prevent future excessive credit cycles. An unforeseen consequence of these actions has been the phenomena of ‘de-banking’, defined as the closure or denial of banking services to existing or potential customers.

The rise in de-banking globally has provided a significant impetus to the growth of private credit markets. As private credit markets have grown to meet the needs of credit starved borrowers, in turn a growing array of opportunities have presented themselves to fixed income investors.

In its simplest form, the banking system (Figure 2) exists to facilitate the transfer of excess capital (savings) to those needing credit (borrowings). Banks use a combination of their existing equity, deposit capital (savings from account holders) and debt capital (raised through issuing their own debt) to fulfil customer loans.

By matching the savings and borrowings, banks generate a positive net interest margin (NIM), which is the difference between their funding costs and what they charge loan holders. Vital considerations for any bank are:

• How do they attract deposits?
• How much debt, and at what price, should they raise?
• What rate do they need to charge on the loans they make? Taking into consideration the probability and likely severity of defaults.

These factors are key to determining a bank’s NIM and ultimately its profitability and return on equity.

In Australia, banks are regulated by the Australian Prudential Regulation Authority (APRA). APRA’s mandate is to ensure banks operate effectively. A crucial component of this role is to ensure banks have adequate capital (the difference between loans (assets) and liabilities (debt)) to weather any systemic shocks to the banking system.

APRA takes its lead from global regulation provided by the international Basel committee. As a response to the GFC, the Basel Committee updated its rules (Basel III). These rules materially altered requirements for the banks, which in turn led to banks altering their customer mix.

One of the most telling Basel III changes was the common equity Tier 1 requirements for the banking sector. To be compliant, banks must hold an increased amount of capital against their risk-weighted assets (loans). Certain loan types, for instance those to non-prime home loan borrowers or loans to startup firms, were more heavily penalised in terms of the level of capital a bank had to hold against them, often to the point it became uneconomic for banks to lend in these markets.

In Australia, one of the impacts of the regulation change was that banks were encouraged to issue mortgages to pay as you go (PAYG) customers, as the capital requirement on these loans became comparatively very low. For mortgage borrowers that didn’t meet these criteria (i.e. self-employed), sourcing a mortgage through the banks became more challenging and expensive. This in turn created demand for residential mortgage lending outside of the bank markets, and is a classic example of the de-banking process.

In addition to the modifications in capital requirements post the GFC, an increased focus globally on anti-money laundering (AML) has placed additional demands on those providing traditional banking services. These demands have placed increased pressure on legacy banking systems and processes.  The domestic incumbent banks have struggled to adapt their systems to meet the new requirements, with both Westpac and Commonwealth Bank found to have failed their AML obligations; Westpac was fined $1.3b for their failures. To minimise the potential for any further repeats of these fines, domestic banks have begun to limit their exposure to only easily identifiable or ‘vanilla’ customers. This decision has led to further de-banking or the denial of services; a problem that has been recognised by the Federal government, as access to banking is considered a basic right and vital requirement.

Limitations in the legacy banking systems of the incumbent domestic banks have also been a tail wind to non-bank lenders in other ways. Rapid developments in IT, including both software and hardware, have allowed newer non-bank lenders (fintechs) to provide high quality and faster underwriting services to non-core banking customers. The traditional banks have not been able to fully leverage these technological advancements as the cost of integrating them into their legacy systems are prohibitive. However, these emerging fintechs need to access debt markets, both public and private, to access funds as they do not hold deposits.

The domestic demand for credit, whether it be governments, corporations, or consumers, is not diminishing and therefore the parts of the market that have been de-banked have needed to find alternative sources of debt capital. As a result an opportunity has presented itself for alternative providers of capital.

The growth in private credit markets over the last 15 years is largely a response to some of the trends that have driven de-banking. Private credit is a broad label and covers a diverse set of subcategories including:

• direct lending
• distressed debt
• venture debt
• private securitisation (warehousing)
• mezzanine finance.

While lending between non-bank parties dates to the creation of credit, the origin of the current iteration of private credit can be traced back to the 1980s, when insurance companies started to lend to strongly performing companies.

An essential element of private credit is that the debt is not traded on a public market, and generally remains an agreement between the initial parties. This contrasts with public securities, where an investor may purchase a corporate bond at issuance, but has the option to easily sell the security to another investor via a market maker. This functionality means that public markets are generally liquid, allowing investors to trade easily with small bid-ask spreads (the gap between what a party is willing to pay for an asset and what the opposing party is willing to accept.)

Private markets not only exist in credit markets but also equity markets, in the form of private equity.  Private investment markets are undergoing rapid growth, as access to these markets has become more readily available to non-institutional investors. The main attraction for investors is that private markets are less volatile as securities are not being constantly exchanged. However, this lack of liquidity presents a significant risk to an investor because they cannot readily redeem their investment if they require the funds. On the upside, investors are compensated for this lack of liquidity and do not constantly face market risk; that is the risk of material price changes that can quickly reverse.

Blackrock suggests that the global private debt market alone will grow from $1.75 trillion in 2023 to $3.5 trillion by 2028. Ernest and Young estimates suggest that at the end of 2021 the Australian private credit market was $133bn. Contributing to this growth has been the knock-on effects of de-banking. On the demand side, borrowers are also attracted to private credit markets as they can execute complex deals with certainty. Generally, terms, including pricing, are negotiated and set up front with lenders who have a greater risk appetite than the traditional banks. This enhanced risk appetite is partially explained by private credit providers not being leveraged themselves, unlike a bank that needs to hold regulatory capital against their investments.

So, how should investors look to benefit from what is on offer in private credit markets? The first question is to assess whether you are prepared to lock your money away for the term of a deal. If one is accessing these opportunities through a fund manager, while it will be the manager’s responsibility to handle liquidity within limits, an investor should still anticipate reduced liquidity.

While under normal operating conditions private credit investors do not face mark-to-market risk, credit risk remains. Credit risk refers to the risk that a borrower will default on their obligations. The most straightforward way to assess this risk is through a security’s credit rating. However, in private credit, many of the transactions will not be publicly rated. Therefore, an investor is either dependent on their knowledge of the transaction or that of their selected investment manager.

Private credit growth is experiencing material tailwinds globally. In Australia, new investment opportunities are presenting themselves as traditional banks retreat from lending to certain cohorts and non-bank lenders step in and fill the capital shortfall. In return for providing this capital, investors receive an enhanced yield and reduced volatility at the inconvenience of limited liquidity. If investors are looking to capitalise on the opportunities presented by the private credit markets, both the benefits and shortfalls need to be considered.

———-

Notes:
[1] Net raisings of debt and equity on conventional credit markets worldwide by each of the non-financial domestic sectors. Australian Bureau of Statistics (September 2023), Australian National Accounts: Finance and Wealth, ABS Website.

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Understanding the intricacies of credit default swaps and how they can be used can protect credit portfolios.

Background

One of the downsides of the Global Financial Crisis (GFC) has been the tarnished reputation of certain financial instruments that were developed with good intentions, namely derivatives. While there is no disputing that the misuse of these products exacerbated the turmoil of the GFC, the original rationale for their existence was to enable effective risk management in financial markets. Credit Default Swaps (CDS) were one such instrument. As this paper explains, when used appropriately, CDS play a vital role in credit markets as they allow portfolio managers to address market and credit risk in an effective manner. Additionally, recent regulatory changes mean that many of the issues pertaining to the misuse of CDS instruments immediately prior to the GFC are unlikely to be repeated.

Financial derivatives have often been portrayed as recent innovations, yet there is evidence to suggest that put options existed in the early human civilisation of Mesopotamia. It is hypothesised that farmers, by decree of the King, had their debts forgiven if there was insufficient rain. The modern finance industry has been responsible for industrialising many of these instruments. In the lead-up to the GFC, financial engineering led to the abuse of many instruments, all of which were developed with the intention of allowing parties to mitigate risk in a similar manner to the Mesopotamian farmers.

The principles of risk management

The role of an investor is to deploy their capital to those in need of capital. In return for their capital, an investor demands a return. At a simple level, an investor can perform their role by either loaning capital to an entity via a direct loan, purchasing a bond, or obtaining equity in the entity by purchasing shares. A share entitles the investor to a share of profits, via a dividend, and last claim over the assets of the entity. The expected value of these components is captured by the share price of the firm. If an investor wants to protect the downside to their equity investment, they can either sell some shares, assuming there is a market, or acquire a put option. A put option means that a counterparty has agreed to acquire a share at a predetermined price. Therefore, the investor effectively removes any downside risk if profits fall, or the company fails.

Alternatively, an investor can be a debt financier. In return for providing their capital for a determined period, either through a direct loan or purchasing a bond, the investor will receive a regular coupon and have their original capital returned at the maturity of the loan. In this instance, if the investor feels the probability of them not receiving all their coupons and/or not receiving the full value of their capital back is too high, they can sell their investment. However, debt markets aren’t generally as liquid as equity markets. An alternative is to find a derivative that can mitigate the risk. In this case a CDS is an appropriate tool for this role.

CDS can also play an important role in the construction of a fixed income portfolio. For example, credit managers wanting to manage the credit duration (the effect of a change in credit spread on an asset’s value) of their portfolio can utilise CDS to adjust this duration by either going long or short credit.

A logical question is, if an investor wanted to go short credit, why would not they simply sell their debt instruments? The answer involves the concept of a portfolio overlay. An overlay is the process of using a derivative, such as CDS, to obtain, offset or substitute specific physical portfolio exposures. There are multiple scenarios where an overlay is appropriate, including:

• Investors may see a short-term, low probability risk they want to hedge against without liquidating their position in an otherwise well performing asset. An example of this scenario was the recent near calamity over the US debt ceiling.
• Credit spreads are expected to move wider over the medium as the business cycle matures. If a manager is holding well performing assets, they may find it difficult to replace them. Therefore, it would be effective to hedge those positions.
• A given market has become illiquid, that is the buy/sell spreads have become excessive, so it would be more cost effective to add the portfolio overlay.
• In most cases a CDS will have a higher beta, in that its price will move by a greater degree than the reference entity. Thereby, allowing CDS to provide a cost-effective hedge.

The birth and near death of CDS

J.P Morgan introduced CDS in 1994 for the purpose of allowing banks to protect themselves against defaults losses within their loan or corporate bond portfolios. A straightforward solution for reducing default risk would have been for the capital providers to sell the relevant security. However, this step might see the capital provider impair their relationship with the borrower, which could lead to reduced opportunities to lend to them going forward.

In basic terms a CDS is an insurance policy, whereby the buyer of CDS is looking to protect themselves against losses arising from a default event. Section 3 details how CDS allow banks, or any other lender, to separate the default risk on loans from the loans themselves. The risk of default faced by the lender is influenced by time, company specific factors and general economic conditions. The price of protection using CDS is constantly adjusting as the probability of a default is influenced by the aforementioned variables.

Unlike traditional equity securities, the original CDS were traded over the counter (OTC) via bi-lateral agreements. Given the agreements related to a single entity or a particular set of loans, they were known as single-name CDS. The original process saw one party look to offload risk by buying protection via CDS, while the party who was willing to accept the risk would be the seller of protection via CDS. The acceptable market jargon to explain the transfer of risk is that the seller is going ‘long credit’ while the buyer is going ‘short credit’.

From humble beginnings, the global CDS market underwent rapid growth in the mid-2000s – the outstanding notional value of all contracts grew from $6.4 trillion in 2004 to $58.2 trillion by 2007. A significant proportion of this growth came about due to speculators, including hedge funds and relatively vanilla mutual funds, utilising CDS to enhance their returns rather than to simply eliminate default risk. This trend saw speculators selling CDS, thereby going long credit as they assumed benign credit conditions and wished to collect the premium payments. This strategy ultimately proved extremely costly at the height of the GFC.

A direct effect of the epic growth in the issuance of CDS was the pricing of default risk. With speculators looking to go long credit, in essence this created an oversupply of CDS, which suppressed credit spreads well below the corresponding spread on the physical asset. This outcome in turn drove additional interest in the CDS market, perpetuating the issuance of CDS right up the onsite of the GFC.

The poster child for the excessive use of CDS was synthetic collateralised debt obligations (CDOs); a product that utilises CDS, rather than a physical pool of assets, to create a CDO. The main upshot from the introduction of synthetic CDOs was a dramatic increase in unseen leverage, as speculators placed multiple positions on the same pool of assets.

Upon the single name CDS becoming widely adopted, regional CDS indices (see Section 3.3) were introduced to cover both investment grade (IG) and high yield (HY) markets. These indices quickly established themselves as the most liquid instrument in the credit markets. Table 1 summarises the main credit indices available in today’s market, with the bracketed number indicating the number of single-names CDS included in the index. The table also provides the tenor of each index, with 5 years being the most common tenor. Section 3.3 provides more detail on the relevance of tenor for the CDS contract.

In the aftermath of the GFC volumes in the CDS market collapsed, though in recent years they have recovered somewhat with the total notional outstanding at end of 2022 being $16 trillion. The collapse in CDS market volumes reflected the significant amount of trading immediately pre GFC that was undertaken by market participants with little or no exposure to the assets underpinning each CDS contract – that is they were placing “naked bets.” This activity was summed up by Warren Buffett, who labelled CDS as a “financial weapon of mass destruction.” The basis of Buffett’s criticism was that, as discussed earlier, CDS became a tool for massive speculation. Originally, speculators ran rampant selling CDS before switching, and bought CDS to achieve a similar outcome as naked-short selling ^[1], placing downward pressure on a host of securities.

A consequence of the OTC nature of the CDS market, including no independent trade clearing process, was the lack of transparency and regulations. The direct result of this was that the parties were simply unaware of the counter-party risk that existed in the market, a matter amplified by the popularity of synthetic CDO. Counter-party risk refers to the risk that the other party in the bi-lateral agreement cannot meet their commitment. Of particular concern was that the sellers of the CDS would have insufficient funds to pay out in the event of a credit event. The specifics of this are explained in Section 3.1.

The significance of the previous point was made clear when global insurance company AIG required a desperate bail-out as defaults escalated across the globe. AIG’s bail-out was required because they had lost track, or were unaware, of their massive exposure to failing mortgage-backed securities (MBS) and CDOs, plus a variety of other derivatives where they had sold protection. Another issue for AIG was that they had completely mispriced the risk instruments they sold as they failed to anticipate any deterioration in default rates.

In very simplistic terms, the AIG situation was akin to an insurer not being able to meet all claims resulting from a major earthquake hitting San Francisco; a situation which would place the capital reserves of all insurers under intense pressure, but particularly those that had chased additional premiums by sacrificing risk. If this situation did occur, would people seek the end of the home insurance market? Likely not; the more sensible approach is to adjust market practices to prevent similar events in the future. As discussed in Section 4, many of the shortcomings of the CDS market have been addressed and the market is now operating with a framework the removes counterparty risk and offers standardised contracts.

Mechanics

The theory

Putting aside speculative behaviour, predating the origination of a CDS contract an investor would have gained physical exposure to a reference entity (a company or loan). To mitigate the default risk associated with the physical exposure, an investor will purchase a single-name CDS linked to the reference entity. Additionally, with the advent of CDS indices an investor can increase, or reduce, their exposure to a group of single name CDS (see Section 3.3). The underlying mechanics of these CDS indices are consistent with single-name contract.

Figure 1 provides an overview of the parties involved in a bi-lateral CDS contract. As stated earlier, CDS are a form of financial derivative, whereby a derivative is a synthetic version of a physical transaction. Therefore, the seller of a CDS, the party going long credit, becomes a synthetic lender to the reference entity. The seller is thereby assuming the reference entity will incur a credit event which would force the payout to the CDS buyer. Critically, the contract does not run in perpetuity, rather the agreement will remain in place for a finite period. This period is known as the tenor of the contract, and per Section 3.2 plays a vital role in the pricing of CDS.

There are three possible payment components to CDS contracts. The first two occur irrespective of a credit event (default), with the third dependent on a reference event.

Upfront payment

Per Figure 1 the first payment occurs at initiation and involves an upfront payment by one of the parties. Post the standardisation of CDS contracts in 2009, this payment represents the difference between the newly introduced standardised quarterly premium (for example, in the US this is 1% for IG credit and 5% for HY credit) and the price of purchasing protection on the reference entity for the tenor of the contract. The latter component is effectively the credit spread for the reference entity. The notional value of the protection being sought also affects this payment.

Section 3.2 provides more detail on this initial payment. In summary, the price of protection considers the perceived risk of the reference entity defaulting, which in turn is affected by the tenor of the protection. The notional value relates to the value of the protection in the event of a credit event. A credit event is an event that allows the buyer to “make a claim” on their contract.

Premium leg

The next payment is the premium leg. This payment takes the form of a quarterly coupon by the buyer and is akin to an insurance policy payment. The buyer makes these payments across the tenor of the contract. With the standardisation of CDS contracts, the premium leg involves a fixed coupon determined by the credit quality of the reference entity. Section 3.2 discusses this issue further.

In a benign environment, this premium coupon looks very attractive to CDS sellers as there is an unlikely (perceived) risk of having to pay out on any contracts. Therefore, the seller is likely to recycle the incoming coupons into other investments. Indeed, this is the trap that AIG fell into, with the outcome compounded by AIG not pricing risk appropriately. Therefore, when it was time to make good on their swaps, AIG had greatly underestimated the funds required to meet their obligations.

Contingent leg

While the bankruptcy of, and payment default by, the reference entity are the main credit events that a CDS buyer seeks protection against, per Table 2, others do exist. If one of these events occurs then based on the terms of the contingent leg, the CDS seller will need to pay-out to the buyer.

Two options exist for settling a CDS if a credit event occurs. Figure 2 presents the simpler option, which is a one-way payment from the CDS seller to the protection buyer. This payment is contingent on the recovery rate of the underlying capital. Within the pricing formula for standardised contracts there is an assumed recovery rate that varies based on the credit quality of the reference entity, An IG CDS contract assumes a 40% recovery, while HY rates are set dynamically.  However, this assumed rate is not a guarantee. Once a credit event occurs a ‘calculation agent’ is appointed to establish a specific recovery rate. This process involves the calculation agent sourcing quotes on the defaulting bond, with this outcome forming the basis of the settlement. Often the calculation agent is the seller of protection.

The other settlement method involves each party delivering either a payment or a security. If the protection buyer is “naked” they will need to acquire the defaulting security so they can deliver the physical security to the protection seller. Given a credit event has occurred, this value will be well below the securities original par value. In return, the protection seller will deliver the notional value of the CDS. In the instance the buyer holds the asset they would transfer the bond and receive the notional value of the CDS.

Pricing

While CDS pricing is highly mathematical, it is relatively straightforward to isolate the significance each component contributes to the “traded rate” or, in simpler terms, the spread. The main driver is the perceived default risk of the reference entity, or entities in the case of an index. This risk will fluctuate with general economic conditions and issues specific to the reference entity. The rate is also influenced by the tenor of the contract, with longer tenors generally attracting higher rates as the probability of default increases with time. This traded rate affects the initial upfront payment and the ongoing mark-to-market value of the contract.

The CDS market maker offers different rates to the market to buy or sell protection for a given reference entity. For the seller, who is going long credit, the higher the perceived risk, the higher the rate at which they will wish to offer protection. Alternatively, for the buyer, they will want to acquire protection at the lowest possible spread. Therefore, a buyer may not want to wait until a default is imminent to purchase protection as the spread will be prohibitive.

An important aspect of the OTC market is the limited transparency of pricing compared to an equity market. In most equity markets, traders can observe the prices that each share parcel of a particular company is sold for and the current trading depth of the market. However, in a manner consistent with the broader fixed income market, and given the OTC nature of the CDS market, a buyer can only see the most recently posted quotes from each of the CDS sellers for a given contract. A buyer may receive either more or less favourable terms depending on how the market has changed since the publishing of the last quotes. The buyer then decides to accept the rate offered by the seller or seek a better rate from another seller.

Once a contract is struck, its value is determined as the difference between the rate at which it was struck versus the latest pricing for equivalent contracts^[2].  Like other financial instruments, the value of a CDS contract will not remain static. CDS buyers (a short credit position) will have the value of their swap decrease if the rates for new contract have fallen, indicating the market’s assessment of default risk has fallen. This result occurs because protection has become cheaper to buy and therefore any contract with a higher rate is less valuable. Alternatively, as credit spreads widen, the buyer will benefit as it would cost more to arrange the same protection.

The above pricing dynamic explains how a credit manager can utilise CDS contracts to hedge. That is, while an adverse credit event, or market conditions, negatively affects the value of their physical assets, the events will positively affect their synthetic portfolio.

Indices

As mentioned in Section 2, as the CDS market matured, various bodies introduced CDS indices. Like an equity index, CDS indices allowed investors to gain exposure to a basket of underlying CDS rather than having to pick and choose single name instruments. Per Table 1, the indices cover a range of geographies, tenors, and credit ratings, thereby providing the flexibility to investors to take a view on certain sections of the market. Additionally, the presence of the indices provided greater liquidity and tradability for those in the credit market, with the bonus of lowering transaction costs and increasing transparency. In terms of liquidity, only the most liquid names are included in CDS indices, thus ensuring that the indices remain liquid and potentially more stable.

There is one significant difference between an equity index and a CDS index, which is that CDS indices roll every 6 months. The rolling process involves creating a new index as the constituents of the index are reviewed, and the new index/contract formed. Despite the new index, the existing contracts do continue to trade, albeit with slightly reduced liquidity and are deemed to be “off-the-run”, compared to the new “on-the-run” issue.

Clearing up the old ways

In the aftermath of the GFC, it became clear that the opaque nature of the CDS market needed to improve. Underpinning this need was the importance of the CDS market in assisting to appropriately price risk across all asset classes. One of the major changes was the introduction of more formalised clearing. The intention of this change was to remove the counterparty risk, as seen with AIG, and therefore restore confidence in the market. The other change was the introduction of standardised contracts.

The most significant change in the clearing process was the introduction of International Exchange Clear Credit (ICECC). Unlike an equity clearing house, which matches buy and sell orders, clearing a CDS requires each party to post collateral in the form of cash or another highly liquid asset to ensure the contracted payments, monthly coupons, or default payments, can be made. The role of the ICECC was to step in as a buyer to match every CDS seller and alternatively be a seller for every buyer. ICECC was set up with multiple layers of protection, including parties posting collateral, to ensure all contracts would be honoured. This process took away the counterparty risk, leaving default risk of the reference asset as the main determinant of pricing.

Conclusion

While financial derivatives are not new, there is little doubt that at times they have been abused and caused excess volatility. One of the many outcomes from the GFC was that investors came to see CDS as recklessly speculative financial instrument. However, the underlying intention of CDS remains consistent with the prudent management of a credit portfolio. That is; a manager wishing to reduce their credit exposure in the face of an anticipated increase in market volatility can utilise CDS for this role. With recent changes to clearing and greater transparency, the CDS can again be legitimately considered a vital part of modern financial markets.

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Notes:
[1] Naked short selling: the tactic of shorting a stock without having properly located and borrowing the shares to be sold.
[2] The value of a CDS also changes through time as the duration of the contract decreases.

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Jason Smit

Alexander Funds is excited to announce the appointment of Jason Smit as Regional Manager for VIC, SA & TAS, based in Melbourne.

Jason will join Head of Distribution, Chris Inifer, to focus on the advice market in Victoria, South Australia and Tasmania and work alongside James Curnow, Regional Manager New South Wales and Queensland, who is based in Sydney. “Alexander continues to grow strongly. Accordingly, it has been important to expand the distribution footprint to service the growing adviser support base. Jason’s addition will allow us to expand our coverage in the Australian market” says Chris Inifer.

Jason has over 15 years’ experience across Australian, US, UK, European, and South African markets. He is a qualified finance and investment professional, ensuring clients receive innovative solutions and professional service. Jason will be a strong addition to the growing Alexander Funds team.

Prior to joining Alexander Funds, Jason worked at Dimensional Fund Advisors in the Wealth Global Client Group, responsible for developing new business and managing existing client relationships. Prior to that Jason spent eight years at RMB Private Bank in South Africa where he was a wealth and investment specialist.

Jason holds a Bachelor of Law and Bachelor of Accounting from Stellenbosch University South Africa. He is also a CFA Charterholder.

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Rachel Shirley

The Alexander Funds Credit Opportunities Fund (the Fund) was awarded 2023 Best Alternative Fixed Income & Credit Specialist Award at last week’s Australian Alternative Investment Awards.

This is the 7th time in 11 years the Fund has won this award. The Fund achieved an annual return net of fees of 6.88% for the year ended 30 June 2023 and no negative monthly returns over the past 12 months.

“We are proud to be recognised for our hard work and dedication to our investors” said Alexander Funds CEO Rachel Shirley, who was in attendance to accept the award. “To have our commitment to delivering high-quality investment options in fixed income and credit acknowledged by the industry is an honour.”

Established in 2005, The Australian Alternative Investment Awards recognise and honour the industry’s top performers. Finalists are decided based on a combination of quantitative and qualitative factors agreed upon by a panel of judges in ten categories.

The Awards support the Alternative Future Foundation, which aims to build positive futures for disadvantaged Australians and their families. They work with charities to make a meaningful and measurable difference in the lives of their beneficiaries. This year’s event raised money for four charities; Redkite, Tranby, Women’s Community Shelters and Nordoff Robins.

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What impact has Japan’s monetary policy had on the world economy over the past several decades?

Japan’s monetary policy changes are one of the key factors explaining both the country’s super-boom combined with huge asset price inflation in the 1980s, and the subsequent bust and long period of underperformance since. Monetary policy changes also set the scene for Japanese institutional investors to become major participants in overseas government bond markets, especially the Australian government and semi-government bond markets, from the early 1990s. Now, as the Bank of Japan is starting to tweak monetary policy tighter, potentially creating the prospect of a positive return from investing at home for Japanese investors for the first time in 40 years, there is growing concern about what impact a potentially large-scale exit from Japanese offshore bond holdings may have. This article will examine how monetary policy influenced Japan’s boom, bust and changing appetite for overseas assets.

The booming 80s

In late December 1989, Japan’s Nikkei share index peaked at an all-time high of 38,916, with PE ratios on many large stocks at more than 100 times. At the peak, one square mile of land in central Tokyo was worth the same as the entire US state of California, and Tokyo golf club memberships topped the equivalent of $US250,000. It was a boom and accompanying asset price bubble like no other, and in its later stages was fuelled by monetary conditions that were set far too easy for far too long.

Over three decades prior, Japan had transformed from an agriculture based developing economy to a manufacturing powerhouse. By the late 1980s Japan was the second biggest economy in the world after the United States.

The way Japanese businesses were structured helped to fuel Japan’s success through the 1960s, 1970s and 1980s. Japanese businesses followed the “Keiretsu” model, where closely related businesses took majority shareholder interests in each other, often involving a bank in the group. This created a platform for Japanese businesses to access capital at cheap rates, which in turn allowed them to spend on research and development on a scale and price that overseas competitors could not match.

As a result, Japanese products were often more advanced, better produced and cheaper than the products of rival companies overseas. Adding to the advantage for Japanese companies, the Ministry of International Trade and Industry permitted the flow of easy credit to the Keiretsu and provided protection against foreign competitors through the 1970s and 1980s.

The resulting extraordinary Japanese business success in world markets prompted speculation in Japanese shares in the 1980s and extended to property speculation, often funded by Japan’s banks. Commercial land prices tripled in the second half of the 1980s and highly priced property formed the collateral for the banks to lend more.

During the late 1980s, central banks globally were generally concerned about inflation that had stayed too high for too long. In addition to high inflation, the Bank of Japan had the extra concern that it could no longer ignore the extraordinary Japanese asset price bubble that had continued to inflate, even through and after the US stock market crash in October 1987.

When it started, the Bank of Japan’s policy response was aggressive. It raised the official interest rate from 2.50% to 4.25% in 1989 and then pushed the rate up further to 6.00% in 1990, continuing to tighten even as the economy and asset prices were collapsing. The aggressive policy tightening was particularly painful because the economy had been force fed on easy credit for so long, leading to lax banking practices that rapidly became exposed. Analysts have pointed to the Bank of Japan tightening policy too much, and then maintaining that policy setting for of too long in the early 1990s, as one cause of Japan’s prolonged recession.

The long recession

The Bank of Japan’s aggressive policy tightening in 1989 and 1990 caused sharp falls in asset prices, destroyed significant bank loan collateral, and led to the unravelling of Keiretsu business arrangements. The quick slide into recession also laid bare issues for Japan’s long-term growth prospects that had been masked in the 1980s boom.

Compared to the shrinking working age group, Japan’s significant and growing proportion of individuals over the mandatory retirement age of 65 tended to save more and spend less of their income.  The working-age cohort was constrained in size due to low levels of female labor-force participation and very low net immigration to Japan. Another factor limiting participation was Japanese employers’ practise of paying higher salaries based on seniority. As a result, relatively expensive older workers were far less likely to be re-employed if they found themselves unemployed.

Japan’s total population would also start to fall in the 1990s. These demographic and employment factors would make it hard for the Japanese economy to grow in the best of circumstances and contributed towards keeping Japan in near permanent recession for a quarter century beyond 1990.

Poor banking practices were exposed with the destruction of loan collateral caused by collapsing asset prices – the Nikkei fell 43% in 1990 and land prices fell more than 40% through the 1990s.  The bursting asset price bubble led to banks accumulating bad loans and an almost immediate increase in bank failures that would eventually peak in 1998, when more than 180 Japanese banks collapsed.

At the time, any official capital injection that might have helped the banks to struggle on was resisted by the authorities as it was regarded as a moral hazard. The notion of moral hazard was reinforced by manufacturing companies arguing to the Government that they had received no capital injections when they needed them, so why should the banks receive any special assistance. The attitude towards capital injections would eventually change in the 2000s and contribute to Japan’s later slow recovery.

In the 1990s, Japanese banks faced diminishing collateral value on loans and mounting bankruptcies among their corporate and personal customers, making meeting prudential capital adequacy requirements onerous. The international Basel 1 capital requirements enacted at the time required banks to hold 8% capital, regardless of economic conditions. Japan’s banks found raising capital to meet prudential requirements hard and responded by reducing loans. Riskier small and medium-sized businesses that often provide the new products and vibrancy to lift an economy out of recession suffered as the banks tried to cut their riskiest loans.

As a result, the Japanese economy was beset by declining bank lending at the same time deteriorating economic conditions were reinforcing the already high tendency of Japanese businesses and households to save rather than spend. Economic growth and prices in Japan entered a cycle of decline that needed a circuit breaker from effective monetary and fiscal expansion to offset the factors reducing private sector spending.

What support that was provided in the 1990s from monetary policy easing and increased government spending was largely ineffective. The Bank of Japan was slow to cut interest rates and provide liquidity support, pushing the economy into a protracted period of price deflation. Even when nominal interest rates were eventually cut, real interest rates – adding in deflation – remained high.

Fiscal policy initiatives in the early years of the recession revolved around more spending on public investment on roads and bridges, not income support initiatives for households and businesses that might have provided a stronger multiplier effect and boost to aggregate demand. The new roads and bridges were were often in rural prefectures, meeting local political, rather than economic, imperatives. Given the rural road system was already of high standard, the new infrastructure was under-used and the economic multiplier from the road and bridge building program was low. It was said at the time that Japan was good at building bridges to nowhere.

These Inadequate monetary and fiscal policy responses made it hard for Japan to escape recession and deflation, especially when the private sector was under constant pressure to try and save more and spend less.

One outcome of the long recession and deflation was that burgeoning Japanese savings sought higher returns overseas. Japan’s conservative institutional investors started a slow increase in asset allocation away from local bonds and towards higher yielding, high quality government bonds outside Japan. US, Australian and New Zealand bonds became popular.  Japanese investment in Australian government and semi-government securities would build through the 1990s to a peak of around 15% of total bonds on issue.

In response to their “lost decade””, Japan was an early adopter of very low interest rates combined with unconventional monetary easing (asset purchases from banks to boost their liquidity) from 2001 to 2006. Ultra easy monetary conditions slowly helped Japan to lift from its long recessionary phase and by 2003 Japan’s annual GDP growth rate was up to 2% – not a fast growth rate, but a sharp improvement on the declining GDP over the previous two decades.

Escaping the long recession

While the ultra-easy monetary conditions of the early 2000s combined with some fiscal easing allowed Japan to lift out of recession, the improvement was a stop-start affair. Japan’s high budget deficit became a concern, prompting budget saving initiatives often in the form of tax increases that were granted with little regard to the state of the economy. As a result, promising economic recovery phases were cut short by budget-saving-dictated tax increases. (Chart 1)

It was not until Shinzo Abe was elected Prime Minister for a second time in 2012 that a suite of policy initiatives was adopted to tackle most of the factors inhibiting Japanese growth and any return to modest inflation. Known as the three arrows and dubbed “Abenomics”, the policies involved:

• government spending initiatives to boost aggregate demand
• very easy monetary conditions including a return to asset purchases or quantitative easing, and
• regulatory changes to help make Japanese businesses more competitive in global markets.

The regulatory changes would extend to trying to combat some of Japan’s most growth-inhibiting practices, including attempts to address Japan’s low female participation rate in the workforce. Also, Japan’s longstanding resistance to migrant workers was tackled by establishing special economic areas where overseas workers could be employed more easily.

The Economist magazine described Abenomics as “a mix of reflation, government spending and a growth strategy designed to jolt the economy out of suspended animation that has gripped it for more than two decades”.

Abenomics was partially successful in its ambitions. Over the past decade Japan’s growth rate has improved and at a current rate of close to 2% y-o-y, is better than growth in the US or Europe. Japanese companies have become more competitive and improved profitability, helping the Nikkei index rise more than 24% so far this year against 16% for the high-flying US S & P 500. Despite this improvement, the Nikkei index still trades 16% below the record set back in December 1989.

Japan has also escaped deflation and returned to modest inflation (Chart 2). At 3.3% y-o-y in June 2023, Japan’s inflation rate is higher than US inflation at 3.0%.

However, the legacy of Japan’s low growth deflationary past still influences Japanese policymakers. There is a tendency to leave monetary conditions too easy for too long given Japan still has significant headwinds reducing its growth prospects being:

• Japan’s population continues to age and fall
• the changes to female participation in the workforce and immigration have been limited, and
• Japan’s savings ratio remains very high.

The Bank of Japan has retained a negative official interest rate even in face of higher inflation and as its central bank peers have lifted their official interest rates by 4 percentage points and more. It has also tried to retain longstanding yield curve control where it targets the yield on the 10-year Japanese government bond at around zero with tolerance of 50bps either side of zero.

However, higher inflation has placed pressure on the Bank of Japan’s yield curve control with the market pressuring the 10-year bond yield to push above 0.50%. In late-July 2023, the Bank of Japan conceded that it could not hold the 10-year bond yield below 0.50% and would tolerate brief episodes of trading above that yield.

As at August 14^th of this year, the 10-year Japanese bond yield at 0.61% is up 15bps over the past month, indicating that the market is continuing to test the Bank of Japan’s commitment to easy monetary conditions.

The signs that Japanese interest rates are finally rising is reinforcing a change in asset allocation by Japan’s institutional investors towards bringing money home and investing at positive return in Japanese bonds. The move is causing some concern that there could be a large exit from their investment in overseas bonds, including their holdings of Australian bonds. If a significant enough sell-off occurs, the resulting weakness in the Australian bond market has the potential to exacerbate a slowdown in the domestic economy and keep our interest rates higher for longer.

This concern is perhaps mitigated by the fact that Japanese bond yields sit well below yields in Australian bonds and will stay well below that given it is likely to be a very slow turn towards tighter monetary conditions in Japan. However, it remains a watchpoint for investors globally given the potential technical impact to pricing from a meaningful reversion to domestic investment by Japanese investors.

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