Fixed-income & change

The year 2020 has been an extremely challenging one for fixed-income market participants, including in the secondary market. ANZ and KangaNews recently hosted a roundtable on the performance of the market in 2020 and what lies ahead in 2021.

Participating in the discussion were Rakesh Jampala, Head of Fixed Income Trading; Chris Khan, Head of Credit Trading, Australia; Ian Ravenscroft, Director, Government Bond Trading; Sarah Valente, Fixed Income Trader; and Glenn Woodward, Senior Bond Trader at ANZ.The session was moderated by Laurence Davison, Head of Content and Editor at KangaNews.

In this second of a two-part discussion, we began by asking about liquidity conditions in the Australian credit market during the early part of the crisis.

CK: The liquidity story was very similar to the financial crisis in many respects and far worse than any of the smaller crises in the intervening time.

There was no imminent threat of financial institutions collapsing on this occasion, but trading conditions quickly came to resemble that period. By this I mean large-scale liquidation – often of the highest-grade bonds, because they were the easiest or only ones clients could sell.

What differentiated this crisis was the speed of the widening but also of the subsequent recovery. This was driven by government support but also by a quicker response from market participants – in particular those conditioned by the financial crisis.

The only meaningful liquidity in the Australian credit market was in bank senior paper followed by – to a lesser degree – in repo-eligible regional banks and offshore financial institutions. These were therefore the bonds clients reached for to sell if needed.

These bonds also had a backstop bid: at some point the large bank balance sheets and asset managers would step in to buy. At the same time, if needed the Reserve Bank of Australia (RBA) would offer these issuers emergency liquidity through the committed liquidity facility or other mechanisms.

Liquidity in tier-two bonds and corporates was, to say the least, very challenging – particularly for corporates. This is because it became necessary to evaluate default risk as well as liquidity risk.

LD: How did ANZ approach this period?

CK: We always endeavoured to show a bid even though, much like the buy-side community, we had no way to predict where the turning point in the spread market might be.

There was also no interbank market into which we could sell risk. We were pricing at-risk bids and, when hit, taking bonds onto the trading book.

Like most market participants, there were no easy days for us during the worst of the crisis. We run an at-risk trading book and significant inventory – unlike quite a lot of banks it is not a solely brokered model.

Our model brings significant P&L volatility. But, rather than shut up shop, we have a duty to try to assist our clients through these times.

This is with 100 per cent support of ANZ senior management in the markets business. They backed our call to keep making markets through the worst of the crisis – and the decision proved to be the correct call.

We don’t have infinite liquidity as a trading book. Far from it – provision of liquidity is scarce and, in stressed conditions, we prioritise its allocation to clients with which we have long-term relationships and have successfully worked in the past. Looking back, I believe we fulfilled our duty.

LD: One of the particular challenges in the financial crisis was the overhang of bonds as investors had to sell to meet redemption pressure. How much forced selling was there this time round, especially as the government allowed early access to superannuation funds, and how did ANZ help manage it?

CK: Superannuation-fund redemption and many clients’ rush for cash had a substantial impact on the credit market and, in particular, the major-bank senior curve.

These floating-rate notes are a major component of many super funds’ short-dated holdings. Selling in this space was compounded by further selling by other investors as they were the only securities in which they could get large-sized bids.

This quickly resulted in the credit curve inverting – the short end traded wider than the five-year point at various times. Our role was to provide bid-side liquidity in what is – relatively – the safest of sectors.

Again, ANZ management was very supportive when we required more balance sheet to support this flow. It ultimately resulted in March and April being the largest monthly flow ANZ has ever seen – albeit substantially weighted toward client selling.

LD: The biggest change in credit-market dynamics has been the absence of the major banks from new issuance. How has this changed secondary-market dynamics around overall liquidity and price discovery in particular?

CK: The RBA’s term funding facility (TFF) has resulted in the largest and most abrupt change to the composition and dynamics of the Australian credit market ever seen.

Due to the TFF, there very likely will be no major-bank or regional-bank senior issuance for an extended period. TFF cash has also driven strong investment demand for these bonds by banks themselves.

This has resulted in spreads collapsing to post-financial-crisis tight levels. Combined with the large ongoing redemption schedule, we have seen the largest segment of the Australian dollar credit market essentially grind to a halt. It is likely to stay this way for a matter of years.

With the major banks no longer frequently issuing offshore, the cross-currency basis swap has collapsed and made the Australian dollar market considerably less appealing for SSA and other Kangaroo issuers.

Traders and investors alike are being forced to focus on a significantly limited universe of investable credit, concentrated on corporate bonds, tier-two and securitisation. Alternatively, investors can expand their mandates to incorporate semi-government bonds or foreign-currency credit markets.

The focus on corporate and tier-two securities has created greater liquidity in these assets. My opinion is that this remains a bull-market phenomenon, however.

Structurally, liquidity is unlikely to be significantly better in future periods of market stress – particularly compared with what we had come to expect in domestic financials.

LD: It has been a consistent talking point for the past decade that banks’ trading capabilities have been fundamentally altered by regulation and the consequent reduced capacity to warehouse bonds. How has ANZ navigated this challenge to continue supporting liquidity for clients?

CK: It’s a similar story across the high-grade and credit sectors. The impact of Dodd-Frank and banks’ reduced ability to warehouse risk was evident to all in the crisis of March and April 2020. The lack of warehousing and an overreliance on broking severely affected the state of liquidity across markets.

ANZ principally runs an at-risk model, under which we warehouse risk and use our global distribution network to recycle it. Our sales team will look to broker risk when necessary but it’s not our primary approach.

LR: To what extent has the Australian dollar market diversified over recent years to provide more genuine two-way flow? It always used to be said that investors were either all buying or all selling at the same time. Has this changed?

IR: The breadth of investors in the Australian dollar market has grown in tandem with its increasing scale. For example, while some might point to a small drop in proportion of offshore holdings of Australian Commonwealth Government Bonds (ACGBs) since the start of the year, the notional volume of these holdings is a more significant figure. This has grown substantially over the same period.

Big thematic moves like those we have witnessed this year will always lead to same-direction client flow. But we certainly see more two-way flow in less volatile periods nowadays.

It is not just an onshore versus offshore dynamic, either. We have clients locally that trade with differing views on the market.

LD: We are looking at ultra-low rates and a lot more ACGB supply for the foreseeable future, with the RBA ready to step in if needed. How will these factors influence liquidity on an ongoing basis?

IR: The RBA has clearly indicated that it is prepared to support the bond market in times of stress. This will underpin investor confidence in ACGBs and semis as the issuers work through greatly increased funding requirements.

We are not immune to volatility shocks, but the likelihood of another risk-off scenario of the magnitude we saw in February and March is somewhat low in a market of coordinated central-bank stimulus on a global scale.

The Australian dollar bond market continues to offer good value to global investors across a number of metrics, including spread to US Treasuries and on an FX-hedged basis. Australia has also been commended for its management of the crisis from a health perspective.

My view is that offshore investors will continue to participate actively in our increased funding needs as they view the Australian market as one of the best investment opportunities globally.

LD: There is a reasonably significant evolution coming to the Australian futures complex, in the form of a new five-year Treasury bond contract. What impact will this have on the cash market?

IR: The five-year futures contract is a key development for our market going forward. It is a very different proposition from the 20-year contract, which has struggled to become an active instrument.

I think physical and derivative markets will react very positively to the five-year bond future, which also brings us more closely in line with international markets. It will certainly provide a more relevant hedge for ACGBs than the relatively anchored three-year bond future.

This can only be positive for liquidity. The opening up of a five-year bond basket provides opportunity for domestic participants that had largely been restricted to activity in 10-year bonds after the change in dynamic at the three-year point.

LD: What is the longer-term outlook for credit trading given the dynamic of little or no major-bank senior issuance?

CK: I think a number of key themes will play out over the coming years. It will be a low-yield environment overall.

Combined with the smaller investable credit universe, this will result in investors diversifying further into the corporate market and into subordinated debt – including financials and the emerging corporate subordinated sector.

Investors with more flexible mandates will also look to add alpha in the semi-government and US dollar credit markets.

LD: Do you expect Australia to become a more rates-focused market in future, based on the drivers of more government-sector issuance, less credit volume and pricing dynamics working against Kangaroo issuers?

CK: Undoubtedly. The unintended consequence of the TFF is a significantly smaller Australian dollar credit market in the short-to-medium term. It will bounce back after these policies are unwound – the major and regional banks will resume issuance, and offshore borrowers will return. But it will be a period of consolidation for 18 months to two years.

While the credit market is facing structural challenges, the ACGB and semi markets are seeing prodigious growth. Providing investors and issuers in those sectors with risk and distribution support is at the core of our focus in financial markets at ANZ.

This story originally appeared on KangaNews