Bird of prey nowhere to be seen
With spreads largely at all-time lows and sourcing real yield proving problematic, asset allocation is challenging for those with constrained mandates. Flexibility in this environment is key. We still identify ample value in the market, but much of this is capital, not carry based.
Although the RBA will decrease bond purchases, we do not see this as hawkish.
We note an interesting choice of language from the RBA’s July meeting; “the Board is responding to stronger-than-expected economic recovery and improved outlook by adjusting the weekly amount (of bonds) purchased”.
In other words, things are better than we thought so we do not need to buy as many bonds. We take umbrage with this. Australia’s deficit is expected to decrease. Accordingly, fewer bonds need to be issued. Therefore, fewer bonds need to be bought on secondary.
Not even considering the conservative nature of the budget forecasts, on a relative basis, we argue that the amount of QE is, at least, staying the same and likely increasing as time passes and the deficit falls. Considering this, has the RBA used the wrong language or is it trying to disguise further accommodation? We think the latter, given that two taper-like events have already occurred that need to be counteracted:
- The TFF tap being turned off; and
- The 3-year bond yield target not being pushed out further.
By in-effect at least maintaining, if not increasing, the amount of relative purchasing, the RBA is further diverging from developed economies in the midst of recovery.
This narrative is supported by Philip Lowe’s own words, stating “we’re going to keep the stimulus going probably longer than the other countries”. In the short-term we expect to continue to see Aussie weakness and a slowdown or reversal in the flattening trade. The risk here is that the stimulus will run too hot for too long and, as illustrated in Figure 1, the Aussie is rarely this cheap with respect to commodity prices.
Given the amount of duration remaining in the system, we remain underweight, as an overheat will be very painful to prices – we prefer floating or hedging fixed bonds with swaps.
The other side of interest rates is that Australia and the US, now having reached the lower bound on unconventional policy, will never be able to unshackle themselves; like Japan and Europe for the past 30 and 10 years, respectively. This is a serious consideration, however with this much stimulus still flowing through the system, it is too early, in our opinion, to make that call.
Looking stateside, we alert readers to the Fed, which two weeks ago, re-priced its reverse repurchase agreement (RRP) facility by 5bps from 0bps. These are small numbers; however, the impact could be large. A RRP rate of 0% provided no real benefit to the banking system besides being a place to park cash. Now at 5bps, hundreds of billions in money markets will storm out of Treasury bills (where bills yield less than 5bps out to 6 months) and into the RRP facility. This is exacerbated with banks draining reserves into the facility. Given banks are now liability contained - in other words, deposits are flowing off - this may create unexpected liquidity issues as was seen in 2019. The increase in overnight reverse repurchase agreements is staggering as seen in Figure 5.
Investment Grade Corporates
The opportunity cost of investing in bonds can be viewed in many ways. In Figures 6 and 8 we show the dividend yield, on an expected and last twelve-month basis, subtracted against the expected yield of a corporate bond index. When the differential is large, bonds appear rich and when it is small, bonds look cheap. There are structural differences in dividend policy between Australian and US companies, with the latter paying out less as dividends as more as buybacks, this transforms the data somewhat, with the US investment grade corporate bond yield normally carrying more than the US equity dividend. Nonetheless, the historic comparison across the cycle is informative.
Whilst on a last twelve-month basis dividend yields make domestic bonds look somewhat cheap, we prefer the estimated future dividend yield given the COVID impact, where many companies cut, or scrapped dividends is looked-through. On this basis, domestic investment grade bonds look expensive – and an extraordinarily large amount of supply has been digested without a hiccup – it really is an issuer's market in Australia presently, which drives our nominal underweight.
The narrative is contrasting in the US, however, given the emphasis placed on capital return, particularly since changes in the tax law, the analysis is opaquer. Regardless bonds are flagging as marginally cheap from an opportunity cost perspective.
It is hard to stomach IG bonds signaling cheap. Spreads are at or near the lowest ever. However, we argue that this is rational for two reasons. First, the Fed, in backstopping the investment grade market, whilst now having withdrawn, has signaled it will provide support in distress – this reduces the need for any liquidity premium, given there is a buyer of last resort in the Fed. Second, spreads should be low given the low average default rates compared to prior history as illustrated in Figure 9. There is merit to suggest spreads should tighten further, which is why we maintain a neutral stance in the US IG market.
High Yield Corporates
Finding the high in 'high' yield is a difficult task these days in the US market. In fact, the yield of the index has fallen below inflation. This is a function of an increase in inflation but also the impact of a frantic reach for yield environment. Additionally, it is true to say that the composition of the benchmark has better credits and can afford to tighten compared to history. From an interest servicing perspective this is true, however we are wary of zombie company exposure.
Whilst we are still finding idiosyncratic opportunities in the USD market, from a beta perspective we are cautious given our position in the cycle. To examine where we are in the cycle, we use our favoured cycle chart, which we first explained here and have subsequently discussed here, here, here and here. More recently the moving average figures have ticked up, placing us firmly within the recovery stage but not with the same velocity as was present post GFC.
Interestingly, the most recent data points, void of moving average (indicated by the red crosses), suggest we could be on track for a mini cycle. This is something we are watching closely. Given cross-asset class valuations, this is not difficult to justify. We note given the enormous quantum of monetary support; it is possible our relationships have broken down. Figure 12 illustrates this best, where the MOVE Index, a proxy for fear in the bond market, is well below the moving average, after only temporarily spiking for a matter of weeks in the height of the COVID sell-off. Nationalisation of credit markets down to investment grade status saw ample liquidity return to the market and drove a stake through any prospect of a lasting rise in the MOVE Index, notably dissimilar to the VIX which remained elevated throughout 2020.
If we are in a lasting recovery, whilst spreads may grind tighter, we feel there is limited margin benefit from a beta perspective. Given the prospect of a mini cycle, we are trimming risk where there is no obvious value case. The output here, in both scenarios, is one in the same, limit USD HY market exposure, unless pursuing alpha in concentrated idiosyncratic opportunities.
Domestically, we have a different view, as a far more fragile market has manifested in limited supply and robust new issue concessions to fair value, with covenant protection and security remaining commonplace. Contrasting that of domestic investment grade, in the high yield market, we continue to see an investor's market.
We are largely overweight here, seeing attractive value in specific securities, at various parts of the capital structure, issued by a variety of entities including Centuria, Peet, Civmec, Avanti Finance, MoneyMe and Nufarm. In our opinion, the biggest problems present in the Australian high yield market are liquidity and diversification, however for institutions and sophisticated investors, we can turn to synthetics to solve for both.
Financials – Regulatory Capital
Hybrids, often overlooked as poor value in relation to equity, have performed exceptionally well in the past 5 years – providing a similar return for far less volatility. Whilst we believe AT1 market performance will moderate given compressed margins, we still view hybrids as providing well-needed capital structure diversity to equity or traditional fixed income investors.
In a post Basel III environment spreads in the AT1 space are tight as ever. We turned overweight on AT1’s in April, noting several tailwinds that would push margins lower. This environment remains and we would look for another ~20bps of tightening before beginning to take profits. The first off the table would be the non-majors, the additional risk has been well rewarded, but it is high beta in a sell-off, so we would look to trim prudently while the market is solid.
Even though value is being squeezed from the market, we are still realising opportunities taking advantage relative value trading in hybrids. Here we look to capitalise on mispricing rather than holding for carry and market compression. In less than a month, our relative value trade on ANZPF recently catalysed a 21% IRR.
We are reducing exposure in Tier 2 credit, being happy to realise profits following our overweight positioning initially in June 2020 and subsequently doubling down in October 2020. Whilst happy to take the additional incremental risk at the AT1 level, in-effect reaching for yield, we trim our Tier 2 positioning to an at best neutral stance. This reduces some counterparty exposure at the pointy end of the capital structure but also capitalises on strong performance.
Our expectations on supply pressures regarding TLAC exposure have moderated, but this is offset by trading at tights and the blurred lines problem we first recognised in July 2019, where APRA stated it “does not consider there would likely be any difference between the point of non-viability and resolution”. We consciously opt to squeeze tights in AT1 instead of Tier 2 but note for those restricted against hybrids, we still see (1) new lows being made and (2) relative value opportunities in Tier 2.
Financials – Senior
On secondary trading we remain underweight in senior unsecured paper. Whilst we prefer the typically floating rate structure, with the TFF having resulted in a vast supply of paper maturing without refinancing, an excess of investor capital has crowded-in spreads. Now with the TFF closed, banks will need to return to capital markets. Margins will improve on primary compared to secondary due to the term, which is not unexpected. It may induce some term rolling, which will place pressure at the front end. We see +$160 billion of potential issuance and are avoiding outstanding bonds on this basis.
Private Debt / Loans
In a 0.10% RBA cash rate environment, finding real yield has become daunting for investment managers. We continue to advocate that those with discretionary mandates should be overweight private debt. Whilst competition is increasing, the capital vacuum left by the banks remains vast. The carry-on offer, alongside risk-return parameters, warrants allocation to portfolios.
Loans, typically being floating rate in nature, offer duration protection. Additionally, domestic covenant control remains strong compared to the US, especially with respect to the syndicated market.
Private debt encompasses a range of strategies with varying risk-rewards. Presently, we prefer the domestic, middle-market, bilateral space but will look to ensure our portfolio is appropriately diversified to reduce idiosyncratic and concentration risk.
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