State Street Floating Rate Fund (SST4725AU) Report & Performance

The third quarter of 2022 saw continued market volatility across all asset classes. Against this backdrop, we assess how the floating-rate segment performed and why fixed-rate repricing should persist into the new year.

A Notable Imbalance Between Supply and Demand
However, another factor was in play. Outside of COVID-initiated supply-chain issues and fossil-fuel challenges driven by the Russia-Ukraine conflict, the withdrawal of pandemic-related stimulus has revealed a significant imbalance between supply and demand in most goods that needs to be addressed. And until an equilibrium of sorts is achieved, higher cash rates, tighter monetary policy, and higher yields will be commonplace.

Floating-Rate AUD Bank Spreads Remain Steady
In market terms, floating-rate senior-unsecured Australian-dollar (AUD) bank spreads managed to hold their ground over the quarter. Even as fixed Australian government bond yields sold off sharply across the curve, credit spreads in senior-unsecured bank notes with bullet maturities traded in a predominantly liquid market. Indeed, it was sometimes hard to source investmentgrade AUD-issued bank paper. That’s not to say there wasn’t intra-month volatility, and on several occasions, we saw equity markets post eye-watering losses.

Forced Selling and Gilt-Market Pressure
On days with blanket selling across most asset classes, credit spreads were dragged wider in sympathy with the risk-off style positioning. Added to this were periods in the latter stages of the quarter when offshore-domiciled liability-driven investment (LDI) funds were forced sellers of their sovereign and credit positions to fund margin calls. This came as the Gilt curve was under enormous selling pressure on elevated inflationary concerns. In this environment domestic investment-grade seniorunsecured credit again mirrored offshore credit in late September by moving wider.

Fixed-Rate Repricing and Weaker
Yields So, as we enter the final quarter of 2022, it appears that in the wake of the sell-off to wides not seen for years, domestic seniorunsecured bank spreads have found an equilibrium of sorts and further substantial widening will face resistance.

For the majority of debt instruments, the first quarter of 2022 was a very tough start to the calendar year as widening credit spreads hit the asset class hard. Senior unsecured floating rate notes did not bear the brunt of the weakness, purely because of their short interest rate duration, but were not immune to weaker global credit markets.

In attempting to dissect the quarter into palatable bite size snippets of what drove the market, it’s worth discussing the three main drivers – building inflationary pressures, the Ukraine invasion and bank issuance. Inflationary pressures both domestically and offshore repriced the yield curve of most developed markets during Q1. It is becoming increasingly apparent with offshore central banks tightening monetary policy and the much anticipated ‘soon to tighten’ Reserve Bank of Australia, that after two years plus of very stimulatory monetary policy, both via traditional and non-traditional methods, the global economy has made it out of the COVID pandemic.

As global central banks withdraw stimulus, coupled with ongoing supply chain issues, we believe that interest rates are going to move higher. In some countries much higher. Globally, there were many investment grade bond indices that recorded their worst first quarter of performance since the 1980’s. It was a brutal move higher in yields, and spread products via fixed credit markets, were dragged along for the bumpy ride. Secondly, was the Russian invasion of Ukraine. For a brief period in late February, the rates market had a risk-off tone as bonds were bid aggressively. This was however short lived. The realisation came very quickly that Russia is a huge supplier of both oil and gas to the global economy. As sanctions were implemented, countries (especially in Europe) procured replacement markets for Russian goods and services, and were willing to pay higher prices that added to already surging global inflationary pressures. Again, bonds were sold aggressively with some fixed income markets seeing eye watering losses particularly in the long end of the curve as yields blasted off from historic lows driven by the pandemic. Credit and spreads were again dragged along for the repricing however short-duration exposures fared much better than, for example, 10-, 20- or 30-year fixed-rate bonds.

The final three months of 2020 in the Australian money market were characterised by the Reserve Bank of Australia (RBA) taking monetary policy into un-chartered waters. As we have discussed in previous insights, central banks globally were adamant that this COVID-19 induced market volatility was not going to become another financial crisis of sorts, and at a minimum, liquidity in financial markets would be buoyed to ensure secondary markets functioned properly and yields would be kept low for borrowers of all calibers.

To that end, the RBA in Q4 2020 reduced the official cash rate target to 0.10% and continued the yield curve control measures whereby Governor Lowe has targeted the 3yr Government Bond Yield, and pegged it to the cash rate target, thereby signaling to the market that monetary policy will be maintained at this stimulatory setting for the next three years. Add to this the announcement by the RBA in November that a Quantitative Easing (QE) program via secondary market purchases was to be added to the already bond friendly yield curve control measures and it was broadly acknowledged that the Australian money market was, if not already, very soon to be awash with cash.

The RBA had also extended its Term Funding Facility (TFF) to authorised deposit-taking institutions (ADI’s) into 2021 which meant that banks did not have to issue notes via the primary market but could instead procure up to three years of funding from the RBA at 0.10%. This combination of multiple RBA monetary policy and liquidity measures, coupled with a TFF ensuring limited primary market senior unsecured issuance in the second half of 2020, compressed credit spreads for the last 6 months of 2020 as market participants sought to invest in existing credit issuance in the secondary market. The market dynamic outlined above for 2020 has the potential to change in 2021. Central banks will taper their additional liquidity measures as both the COVID-19 vaccine(s) are distributed and economies get back to the new normal. As global markets, and in particular rates and credit markets, have seen in previous periods where central banks reduce stimulatory measures, there is the likelihood of ‘taper tantrums’ where markets object, albeit briefly, about the reduced access to cheap money.

If there is a tapering of stimulatory measures, this will be a confirmation of the fact that both employment, growth and potentially inflation are back on track and Governor Lowe deems such extraordinary additional market liquidity measures are no longer warranted. If this scenario were to play out and tapering were to begin at some point in 2021, bonds would lose their secondary market QE driven bid from the RBA, inflation would again start to hit economists radars, the TFF would be retired and banks would start issuing senior unsecured debt again into a market that isn’t awash with surplus funds, and investors will be able to buy in the primary space higher yielding, highly liquid senior unsecured bank names. Acknowledging that is a lot of ‘ifs’, even if only a portion of this scenario plays out this year, it still bodes well for floating rate senior unsecured bank debt in 2021. The State Street Floating Rate Fund outperformed the RBA Cash Rate again in Q4. The portfolio as at 31 December was running a spread duration of 2.84 years, had an average credit quality of A+/A and had an average coupon of 0.93%.