Fixed Income

There’s a common question being asked of economists, money managers and financial commentators these days; are we mid-cycle or late-cycle? The honest answer is that we don’t know and we can’t know until the cycle has seen a severe downturn. We can clearly look back and say that the yields available on almost all asset classes are far less than they were five years. Yet we can’t predict the future; and we could see further yield compression from here or a long period of no change. However, in the spirit of having a view here’s a few anecdotes that point to the credit cycle being much closer to the end than the middle.

This week an Austrian bank sold €500m of preference shares (aka hybrids or CoCos) at a 3.375% dividend rate but had bids for 10 times as much as it sold. This is the second lowest yield ever printed for this type of security. The yields on European subordinated capital securities have fallen markedly over the last year with investors increasingly dismissing the structural and solvency risks that come with these securities.

Whilst bank hybrids have been a yield chasing tool of choice for Australia retail investors, the flavour of the month overseas is structured products. Investors in the US, China, India and South Korea have been punting on investments that offer the prospect of additional yield by selling options linked to currencies, equity prices or volatility. These trades tend to work well when markets are relatively calm, but burn investors when volatility picks up and asset prices fall.

The massive growth in private debt in the last decade has been well chronicled. This is partly a structural phenomenon as banks have reduced their remit and left more room for other lenders. There’s also been recognition that when done well, this sector delivers returns higher than vanilla equities with far less volatility. The current outlook for private debt could be summed up with the adage that “what the wise man does in the beginning, the fool does in the end”.

As the flood of money entered the sector in the last few years, yields have fallen and risks have increased. The increased risk can be seen in the reduction of covenants, the proliferation of earnings add-backs and the expansion in leverage multiples. Some lenders have responded by pushing into less competitive territory, often looking to lend to smaller and younger businesses. For some lenders, borrowers that don’t generate a profit and in some cases don’t even have any revenue are still considered bankable.

One more type of anecdote that often makes an appearance at the late stage of the cycle is the “this time is different” variety. Hedge fund behemoth Bridgewater is well known for its view of how the economy works and the drivers behind business cycles. This week its co-CIO made the comment that “we’ve probably seen the end of the boom-bust cycle”. This closely followed a remark from Bridgewater’s founder that “cash is trash”. This is an interesting turnaround in sentiment from a firm has badly underperformed the S&P 500 since 2012 due to its conservative risk positioning.



Ruth Kassulke

My concern is this. Govt wants to kick the can down the road as far as possible. After QE, they will try money printing. As asset prices escalate, the returns do not without a corresponding increase in dividends, i.e. productivity of the company. If an asset produces 10% p.a. and increases in price by 10 times (which seems to be happening via QE), your return is now 1%. What happens when it increases 10 times again? Surely there comes a point when investors are not willing to risk capital for a return of 0.1%? You can sit on cash, but you do not know how long this process will take, and I wonder whether a cashless society will eventuate and banks will charge you to deposit savings. In the end, it seems the only way out will be to inflate away debt by money printing, which should trash the currency. I am disappointed the RBA lowered rates, because I think this easy money supply will end badly, and the winning countries/individuals will be those who carry serviceable debt against real assets only (because the debt will wind up being inflated away), not those who are carrying debt for any other reason (such as promised or existing entitlements). Does anyone have any thoughts on this?