Not all state government debt is the same and the ballooning of debt in some states is increasing risk in credit markets, warns Perpetual’s Greg Stock.
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Governments have continued to take on significantly increased debt levels post-Covid, but they’ve been slow to repair their increased structural budget deficits.
That’s according to senior portfolio manager and head of credit research Greg Stock, who manages the Perpetual Active Fixed Interest Fund.
“They have continued to spend – and it’s beginning to catch up with them,” he says.
“It’s been happening here, in Great Britain, in America, in Canada, all around the world.”
State governments have not been immune to the trend, and that has triggered greater risks for investors in semi-government bonds.
“Interest rates remain elevated and while inflation has come down, we haven’t seen much rate relief,” Stock continues.
“Recently we’ve seen a downgrade of state governments by ratings agencies, notably Victoria and Queensland.
“There’s now more risk in semi-government bonds than previously.
“They are now cheaper (higher relative yields reflecting increased risk), so you could argue they’re better value.
“While risks of default are low, there is growing ratings migration risk and liquidity risk.”
Passive funds may feature issuers with higher debt
It is slightly perverse, but the weaker an issuer’s debt profile, the more debt it likely has outstanding, meaning it becomes a bigger part of the composite bond index, Stock says.
“If you are a passive investor, you are more exposed to an issuer that issues more debt. And by and large, an issuer that has more and more debt is not what investors want. In the case of state government component of the index, it has increased substantially.”
Stock says currently the federal government comprises almost half of the composite bond index in Australia, and states are approximately one-third.
The critical point is that investors manage risk in their bond portfolios.
The index is not an investment strategy, as Greg has proven with an outstanding top quartile 15-year track record of outperforming the index by seeking a well-diversified portfolio of credit securities.
“If you hadn’t managed risks in a bond portfolio, you would potentially be overweight certain semi government bonds whose credit risk was deteriorating, as was their relative price.”
Stock has positioned his fund more conservatively when it comes to state debt, with exposure to the stronger performing states of New South Wales and Western Australia, and reduced or no exposure to Queensland and Victoria.
He prefers to seek better income opportunities in high-quality corporate and asset-backed securities to generate more income while maintaining a higher quality credit profile than potentially some of the state government bonds.
“Those last two states are struggling with their debt profiles, there is a risk their ratings could go down further.
“Investors are well served in bonds to be risk aware in their portfolios to achieve strong risk adjusted returns.”
Looking ahead, Stock notes that yields are rising for state government bonds, which means potential opportunities to earn higher returns in the future.
“Australian bonds overall should be a great investment over the next five-to-ten -year timeframe.
“If you can earn 5-6% income with low risk, it's a good outcome for any portfolio.”
About Greg Stock and Perpetual’s Active Fixed Interest Fund
Greg Stock is a Senior Portfolio Manager and Head of Credit Research with Perpetual’s Credit and Fixed Income team.
Greg has more than 30 years of experience in investing, including 20 at Perpetual.
Perpetual Active Fixed Income Fund offers investors diversification and risk management via exposure to a hand-picked selection of mainly corporate and government bonds.
The portfolio invests across a wide universe of Australian debt securities. Greg and the team aim to identify quality credit investments while actively managing risk. The fund aims to provide regular income with quarterly distributions.
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