Australian companies are enjoying a backdrop of favourable macroeconomic conditions, including above-trend global growth and gently rising inflation. However, risk assets appear somewhat vulnerable to a correction as valuations approach fair value, market-implied volatility remains low, and central bank easing unwinds.

As my PIMCO Australia colleagues recently published, this combination of a strong fundamental backdrop accompanied by fully priced assets means that sector selection and bottom-up company analysis matter more than ever.

In this context, there are many opportunities for Australian corporate bond investors, especially in sectors such as energy and infrastructure, but we are similarly cautious on longer-dated exposure to domestic banks, utilities, retailers and select real estate investment trusts (REITs).

Credit fundamentals looking positive

Using a selected representative sample of 39 Australian corporate bond issuers from the ASX 100 (excluding financials), we tracked a variety of credit ratios and found that corporate leverage (net debt/EBITDA) is about 2x. Free cash flow and debt serviceability levels have improved over the past decade, helped largely by lower interest rates, but in 2017 also via an encouraging earnings recovery.

Also, companies should be able to internally finance a modest recovery of capital expenditure and as a result, net supply of Australian credit will likely remain below demand.

Sector selection matters

While aggregate leverage metrics should remain fairly stable over the next few years, there will likely be clear divergences among sectors. Although, on the whole, valuations are high and credit spreads are tight, we believe there are ample relative value opportunities within the Australian credit universe. These may be captured by investing in line with a strong secular theme or by identifying a turning point in a company’s capital expenditure, strategy, or earnings outlook.

One secular theme is the rapidly changing profile of energy generation, which will create both winners and losers within the energy and infrastructure sectors. New infrastructure for transmission, storage and production of renewables and gas will be required, while other methods of generation may become less productive or useful, or even redundant (such as low quality thermal coal).

For example, Australian oil and gas producers have just completed a multi-year period of high development capex, driven by the creation of the East Coast gas export market and construction of large-scale liquefied natural gas (LNG) projects, which were largely funded by debt. The industry is now in a stage of balance sheet consolidation and repair, assisted by improved earnings from higher production levels and commodity prices. As these projects continue to ramp up output, revenues are growing while total capex is falling to levels needed only for operational maintenance, providing a strong tail wind for balance sheet improvement.

Additionally, high growth in the Australian infrastructure sector is affecting corporate issuers directly, via growing investment expenditures and associated debt issuance, as well as indirectly, as reflected in the scarcity of high quality Sydney office space, which has pushed up rents as buildings are razed to make way for new transport projects.

Sectors such as airports are likely to be long-term beneficiaries of growing international visitation to Australia, as Australia’s high level of international migration and Asia’s rising middle class drive passenger growth.

Conversely, bond investors should view with caution those sectors that are overly exposed to the highly leveraged Australian consumer. Household consumption will likely continue to run at a much lower average level as wage growth remains low, a slowing property market reduces wealth effects, and savings rates stabilise. Retailers may prove vulnerable, particularly those exposed to falling barriers to entry and higher competitive pressure, as well as select retail and developmental real estate investment trusts.

In an environment of increasing volatility and tight valuations, careful security selection is vital. While a company might look attractive at first glance given its growth profile and the potential of the sector as a whole, detailed bottom-up research is still crucial to pick the winners.

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Robert Mead is the managing director and co-head of Asia-Pacific portfolio management at Pimco.

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