As we transition to a new normal where yields are dead, many asset classes – and the investors who populate them – haven’t yet come to terms with risk-free government bonds that pay four to five percent a year. With the RBA’s cash rate expected to be around 3.5 percent in a few months, government-guaranteed bank deposits will offer the same rates.
Since these bonds are perfectly liquid and risk-free, anything riskier than Australian government debt must beat that 4-5 per cent yield hurdle! In other words, you need to receive compensation for both the additional credit (or capital loss) and illiquidity risks. A former saying was “there is no alternative” to chasing risk. Today, there are many risk-free or low-risk alternatives to chasing risk.
Commercial properties are a classic example. Jonathan Kearns of the Reserve Bank of Australia Highlighted recently that while government bond yields on 10-year bonds had jumped from 1 percent to 4 percent, office, retail, and industrial/ commercial property yields hardly shifted.
In the last few years, commercial property has earned the lowest return premium over risk-free government bonds. Historically, commercial property has paid a 4-5 percent annual extra yield above Commonwealth government rates. That has dropped to 2 percent or less recently, suggesting that commercial property yields will have to rise sharply.
In order for that to happen, commercial /industrial values must fall sharply, which is what normally happens during a recession. The regulator doesn’t like banks lending much to commercial property owners or residential developers because these sectors have been the single biggest bank killers over the past 150 years.
Due to their exposure to commercial property in 1991 many developers went bankrupt or had trouble accessing bank finance. Many developers are now forced to borrow from non-bank lenders, having to pay interest at the high rate.
Due to illiquidity in the commercial property market, buyers and sellers cannot agree on current property values that are based on much higher yields. Loan-to-value ratios will increase, and borrowers might breach loan covenants if they reported large write-downs of their asset valuations. In particular, listed real estate investment trusts (REITs) claim enormous valuations for their assets that are substantially different from what the market values them at.
It is estimated that retail and industrial REITs trade at a 20-25 percent discount to their net tangible assets, while office and diversified REITs trade at a 30-40 percent discount. The RBA’s analysis implicitly supports the assertion that sophisticated equity investors do not believe the accounting valuations of REITs’ underlying properties.
It is difficult to adjust valuations in illiquid asset classes such as commercial property, residential property, infrastructure, private equity, and venture capital when interest rates change suddenly.
Despite the 30-plus percent reduction in buyers’ purchasing power, house prices are likely to continue falling for at least another 6-18 months following the RBA’s May rate increase and subsequent rate increases.
There are also approximately $500 billion in fixed-rate home loans charging only 2-4.25 percent interest rates, which will switch to variable rates over 5 percent over the next 12 months. It is no wonder that the RBA’s boss, Phil Lowe, believes he has time on his side.
At various points this year, global stocks have fallen 30-40% from their 2021 peaks as a result of rate changes.
It is unprecedented for the RBA to increase its cash rate by 300 basis points during inflation-targeting. Equity prices are pricing both current and future interest rate increases.
The RBA signaled on Friday that the terminal rate would be 3.5 percent instead of around 4.5% next year. Financial markets are therefore pricing in a terminal rate of around 4 percent sometime next year.
Fed policy rates have risen from 0.25 percent to 4 percent in the US, and they are expected to rise to 4.5 percent in the coming month. A terminal rate of about 5.2 percent is expected by the bond market, which the equity market is adjusting to (higher discounts mean lower prices).
There is no way to know if listed equities have adequately priced in the reduction in earnings that will occur as a result of a significant slowdown in economic growth. Before the market reflects these changes in corporate valuations, it may need to see hard evidence in the form of material earnings downgrades.
A bond market, which is determined by current and expected interest rates, is the only asset class that immediately reflects these changes. On a five-year senior bond with an AA- credit rating last year, CBA paid just 0.26 per cent interest.
An interest rate margin (or credit spread) reflects the premium that CBA pays over a proxy for cash rates, which is the quarterly bank bill swap rate (BBSW). In mid-2021, the credit spread on a five-year CBA senior bond was just 0.25 percent above BBSW. In comparison, BBSW was only around 0.01 percent.
The yield on BBSW has soared from 0.01 per cent to 3.0% today, and the yield on CBA’s senior bonds has risen from 0.26 per cent to 1.2 per cent. Therefore, CBA has to pay a total interest rate of about 4.3% on this type of debt, double what it would have paid last year.
Similarly, a 10-year South Australian government bond with an AA+ rating paid a fixed interest rate of just 1.2 percent in December 2020. Today, it pays 4.7 percent.
In response, the big four banks have pushed out their BBB+ rated tier 2 bonds, which rank behind their senior bonds in the capital stack but above their BBB-rated hybrid bonds.
It was estimated that a CBA tier 2 bond would yield a floating interest rate of 1.26 percent last year based on a spread above BBSW of about 1.25 percent. This floating-rate CBA bond currently has a total annual interest rate of about 6 percent because the spread has increased from 1.25 per cent to about 2.9 per cent above BBSW.
Fixed-rate CBA bonds, which factor in both future and current expected RBA cash rate increases, offer a much higher interest rate.
Based on this, it is clear that changes in the central bank’s risk-free policy rate ripple slowly through the economy, much like the waves created by someone diving into a lake for the first time. Coolabah’s internal modelling indicates that RBA rate increases today can affect future inflation by one to five years.
In their respective statements this week, the RBA and the Fed both emphasized the long and variable delays associated with monetary policy adjustments, as well as the fact that rates have already been raised rapidly.
On Thursday, the Bank of England likewise signalled that most of its heavy lifting had already been done after a 75-basis-point rate rise took its policy rate to 3 per cent, dismissing market expectations for another 200 basis points of increases.
Globally, central banks appear to be making a coordinated effort to signal to markets that they will cut interest rates modestly as they observe the real economic impact of the huge increase in borrowing costs over the last six to nine months. The approach is perfectly sensible.
At the same time, it is important to assess whether your asset valuations are accurate.