2019 Australian Semi Update – Staying long, switching to AAA

By Robert Thompson
Published October 2, 2019

We ratchet tighter our expected Australian semi-bond and semi-swap bond trading ranges for the remainder of 2019 and recommend staying moderately overweight the sector.

The recent tightening of semi-bond spreads has taken some value out, but we would continue to hold longs versus bond and add on backups. Semis also currently look decent value to swap on some parts of the curve, though we are more tactical on this front.

On the supply side, upward revisions to AAA capex-related issuance are now fully out in the open and adequately priced in. We had flagged this as a risk for AAA spreads heading into the FY19–20 Budget season. From this point, though, spreads to bond should drift lower and AA+/AAA spread compression has probably run its course, so we prefer AAA paper for our core long positions. At the moment, we also favour the long-end given relatively steep spread roll-down.

From a risk perspective, it makes more sense to own AAA here even if AA+ spreads still hold in well. This switch into AAA for our core long positions is in line with our previously indicated strategy at the start of the year, where we positioned for further AA+/AAA compression until after budgets were unveiled. Despite a low set of net issuance requirements and commodity royalty tailwinds, AA+ states are unlikely to keep compressing much more to AAA given that pickups are now just 0–5bp across the curve. Heightened macro volatility is another reason to stay in the higher-rated issuers, with any risk-off credit events likely to widen AA+/AAA spreads. NSW and VIC also have more fiscal headroom in the event of operating balance deterioration, with greater leeway to cut or delay their significant capex tasks should they need to preserve budget metrics and/or rein in financing tasks.

The demand picture has also improved lately, supporting our view that semi spreads can move tighter. Yield enhancement has already proved a powerful supportive theme so far this year, and with plenty more rate cuts likely to come globally, this will keep downward pressure on semi spreads. Future balance sheets demand has also been boosted by the tweaks to the LCR.

So after previously riding the AA+ wave with a series of spread compression trade recommendations centred on QTC and WATC, we have now closed out all of our AA+ risk in favour of AAA paper. Our first foray on this front was a TCV Oct-28s EFP narrower entered in late June, followed by a NSWTC May-26s/Feb-30s spread flattener. At the moment, and despite some tightening over the last month, semi spreads to bond remain toward the upper end of our expected trading ranges. 10y AAA is at about 49bp within what we expect to be a 35–55bp range (see page 2 for full expected ranges). We would look to move more overweight the semi sector on spread-bond back-ups of 5–10bp across the curve.

Robert Thompson
Macro Rates Strategist, Australia