Defensive portfolios just got a wake-up call on rates

Six months ago, income clients wanted to know how many more rate cuts were coming. In the week to 24 July, the market flipped that question on its head. The RBA’s cash rate still sits at 4.35 per cent, unchanged. But traders stopped pricing cuts from here and started pricing hikes instead.

Australian bond yields moved sharply across the curve. The 3-year jumped 23 basis points in five trading days, to 4.72 per cent. The 10-year rose 18 basis points to 5.08 per cent. The 30-year added 11 basis points to close at 5.56 per cent.

Every tenor on the curve moved the same direction at once. That is unusual, and worth sitting with. This was not a rotation between maturities. It was a repricing of the whole path.

Barrenjoey economist Jo Masters has flagged sticky inflation as the trigger. Categories that do not respond to a single rate cycle, among them restaurant meals, hairdressing and construction costs, are running hot enough that she sees reason for the RBA to move as soon as its 11 August meeting, with a further increase possible in November.

Money markets are leaning the same way. Three-month BBSW closed the week at 4.49 per cent, its highest weekly close in some time. Swap rates out to 15 years all moved higher in step with the bond curve, for the first time in months.

What this means across defensive allocations

Term deposits

The best value currently sits in the 6-month to 1-year range, where competition among providers is deepest. The 1-year segment averaged 4.98 per cent, with a median of 5.20 per cent and a top rate of 5.40 per cent from Military Bank.

The segment is also unusually tight: the gap between the top and bottom quartile has narrowed to 0.25 percentage points.

The difference between an average provider and a leading one is small. Further out the curve, that is not true. Two and three-year deposits show quartile spreads of 1.25 to 1.30 percentage points. Provider choice matters far more the longer a client locks money away.

A laddered structure across 6 months, 1 year and 3 to 5 years captures the best of both worlds: strong near-term rates, and some protection if the curve keeps moving.

Government bonds

The longer end is the one to watch closely. In the US, the 30-year Treasury yield has held above 5 per cent for its longest stretch since 2007. Back then, the Fed’s policy rate was around 150 basis points higher than it is now.

The backdrop has shifted too. The US Treasury market has grown from $4.5 trillion at the time of the global financial crisis to $31 trillion today. Federal debt has passed 100 per cent of GDP.

Annual interest costs now exceed $1 trillion. Layer on more than $500 billion in expected debt financing for AI infrastructure, competing for the same pool of long-term capital, and the picture gets clearer: portfolio managers are increasingly avoiding maturities beyond 10 years. Many are favouring the 5 to 7 year segment instead, where income holds up but duration risk is lower.

The same logic applies to Australian bond yields. The 3-to-10-year spread on Australian allocations has held a positive slope through this repricing, so there is compensation for extending duration. But it comes with more volatility than the front end.

Hybrids

Worth a second look, for the opposite reason. The median hybrid margin over 3-month BBSW closed the week at 1.64 per cent, its narrowest reading on record, well below the 7.34 per cent spike of March 2020 or the 5.61 per cent peak of February 2016. Judo Capital led standard issues at 9.99 per cent all-in yield.

Latitude sat at 9.24 per cent, and Macquarie Bank Capital Notes 2 at 9.10 per cent, still a clear premium over major bank paper. But a margin this tight pays investors comparatively little for the credit and structural risk hybrids carry.

That is worth raising with clients who hold hybrids purely for yield, without weighing what happens to that margin if credit conditions turn.

The conversation to have now

Clients who built defensive allocations on the assumption that rates would keep falling are now sitting inside a market pricing the opposite.

That does not mean panic-selling duration or chasing the highest advertised term deposit rate. It means checking whether existing ladders, bond holdings and hybrid weightings still match a “higher for longer” world.

Advisers built many of these portfolios for the easing cycle everyone expected six months ago. The next two weeks, running into the RBA’s August meeting, will show whether Australian bond yields hold at these levels or partially unwind.