Corporate bonds catch Franklin Templeton’s eye

The Australia Fixed Income team at investment management firm, Franklin Templeton, has singled out investment grade Australian corporate bonds for their attractive total return potential.

Andrew Canobi, Director of Franklin Templeton Fixed Income and portfolio manager for the Franklin Australian Absolute Return Bond Fund, said the slow repricing of high quality investment grade corporate bonds looked promising in the last three months.

“Each of the three components of corporate bond pricing – government bond yields, swap spreads and credit spreads – all three layers of the cake, if you like, are attractive now,” he said.

Canobi also said he believes government bond yields will decline as the rate expectations bubble begins to deflate, swap spreads return to their long-term averages and credit spreads remain where they are now.

This outcome would likely have a positive impact on the performance of the corporate bond sector in the next one to two years.

The three-year government bond yield is placed around 150 basis points above the Reserve Bank of Australia (RBA) cash rate. This suggests an expectation among the market of almost 150 basis points in interest rate hikes in the next year.

“If you believe this is overdone and highly unlikely to be realised, which is our view, government bonds are cheap,” Canobi said.

Investment grade spreads measured by the iTraxx Australia CDS Index are close to their wides of the last 12 months, with Australian utility and real estate bonds rated in the single A or high BBB categories trading at yields just under three per cent.

“Higher yields mean lower prices. These bonds with 3% yields are trading below their par prices of $100,” Canobi said.

“The return on offer is the coupon income plus the ‘assured’ capital gain from buying a bond at, say, $95 and then seeing it return to its par price.

“Corporate bonds could become ‘cheaper’ in the short term if their yields go higher. But total returns now look compelling.”