Fixed Income

This week I reflect on the intensifying FOMO rally driven by the expected search for yield dynamic that has been triggered by RBA rate cuts, the prospect of the Fed following suit, and the likelihood that the ECB will recommence its corporate bond purchasing program, amongst other things (click on that link to read or AFR subs can click here). It never ceases to amaze that when credit spreads were very wide (and historically cheap) last year, supposedly sophisticated investors were negative on the sector, if not redeeming altogether. Now after spreads have recovered much of this widening, these same folks are falling over themselves to pick up what are much more expensive assets in a desperate attempt to maintain yields. Whereas we were aggressive net buyers of credit last year, we have been firm net sellers in 2019. 

One of the interesting new developments we've seen in this context has been the proliferation of listed Australian credit ETFs and LITs, which can result in a price-agnostic bid for assets (we of course run the absolute return BetaShares Active Hybrid ETF strategy, HBRD). While I think giving retail investors more exposure to fixed-income, and new parts of the market, is a terrific development, price-independent investing is clearly something that can cause problems in portfolios. Overall, these new players have injected significantly more liquidity into the market across a highly fractured/decentralised retail investment base, which is a very constructive innovation over the medium term. Super fund portfolios were massively underweight domestic credit (compared with their domestic equities exposures), and the retail market is rectifying this imbalance.

Folks often like to opine on liquidity in secondary credit markets, but in my experience as one of the larger traders of Aussie credit, they have zero clue what they are talking about. First, secondary liquidity is much, much better than many claim, and generally superior to what was observed prior to the GFC in bid/offer spread and secondary turnover terms, according to the US Federal Reserve's analysis. Second, liquidity is orders of magnitude greater if you are a contrarian, buying when everyone is selling, and selling when folks are scrambling to pick up assets. And now an excerpt from my column this week:

The French bank BNP offers one illustration of this dramatic change in the investment zeitgeist. In November 2018, BNP was barely able to raise EUR500 million of funding in its home market via a Tier 2 subordinated bond despite offering up a hefty 40 basis points concession in extra annual credit spread terms beyond what was required in the secondary market. Dealers at the time reported that this very cheap issue was only just covered with EUR675 million of demand.

Fast forward to July 2019 and BNP completed an even riskier Additional Tier 1 capital hybrid issue in the otherwise foreign Australian dollar market that attracted an astonishing $3 billion of demand notwithstanding BNP offered zero credit spread concession relative to where its hybrids were trading in the US dollar market. Even when BNP slashed its proposed spread to levels that were 50 basis points below where you could buy identical securities in US dollars and swap them back into Aussie dollars, demand remarkably remained around $2.4 billion.

In November last year Bendigo Bank struggled to refinance a $300 million Tier 2 subordinated bond maturity it had coming up in January, issuing just $275 million of these securities at an attractive spread of 250 basis points above the bank bill swap rate (BBSW). (We bought over $50 million.) Today that security is bid some 62 basis points tighter in credit spread terms at 188 basis points over BBSW, which has driven up its initial $100 issue price to over $102.

In late 2018 market-makers were reluctant to bid for more than $2 million of individual Tier 2 bonds despite the wide spreads. Today it is not uncommon to see bid volumes of $20 million or more even though spreads have crunched in 50 basis points and appear expensive relative to levels available in years gone by. Of course, if you bought Westpac’s five-year Tier 2 bond in February 2018 at just 140 basis points over BBSW, which was by far the tightest spread observed in major bank paper since the 2008 crisis, today’s circa 180 basis point levels do not look terrible.

We’ve observed similar price action in the ASX listed hybrid market where five-year major bank hybrid spreads have crunched in from 356 basis points above BBSW before the federal election to 271 basis points today, which is still some 40 basis points wide of the post-crisis "tights” touched in mid 2014.

Recall Unisuper’s John Pearce pumping $300 million into NAB’s hybrid (NABPF) in February 2019 at a spread of 400 basis points over BBSW (we also subscribed to the issue)? That puppy is now trading almost 100 basis points tighter in spread terms, which has lifted up its capital value from $100 to $106.

That’s why bond investors are technically correct when they say that you can get equity-like returns from fixed-income right now. Last week I explained how a portfolio of highly-rated fixed-rate bonds have delivered incredible returns as market estimates of the long-term government bond yield have contracted sharply. In particular, the AusBond Composite Index is up 9.57 per cent over the past 12 months despite only yielding about 2.2 per cent, on average, over this period (our wholesale Active Composite Bond strategy has returned 12.7 per cent before fees over the same horizon).

One can capture these capital gains through predicting changes in the risk-free rate (ie, the market’s best guess of where the long-term RBA cash rate is going to be plus some compensation for interest rate uncertainty), or through anticipating variations in the credit spreads corporate and financial bond issuers pay above the risk-free rate when they borrow money.

I personally don’t know any investor who has been consistently successful at exploiting mispricings in global interest rate markets, which are immensely competitive and efficient. This is why around 90 per cent of active bond managers have underperformed the AusBond Composite Index over the last 10 years according to Standard & Poor’s (ie, they tend to get their interest rate bets consistently wrong).

Exploiting inefficiencies in global corporate and financial bond markets is, by way of contrast, much easier, precisely because these asset-classes are replete with mispricings.

Another difference between the government and corporate/financial bond markets right now is the shape of their respective yield curves. With markets pricing in an average RBA cash rate of around 1 per cent over the next decade, you are getting little compensation for future interest rate risk. That is, while the cash rate is getting close to its effective lower bound, there is significant theoretical downside risk for fixed-rate bond holders if, heaven forbid, rates ever normalise.

In contrast, corporate/financial bond yield curves are clearly positively sloping, which means that credit spreads are increasing as a function of time, as they should. This does not necessarily mean that the spread itself appropriately compensates you for the bond’s inherent default risk (ie, that spreads are sufficiently high).

As we’ve highlighted before, (non-financial) corporate credit spreads are back in line with where they were before the 2008 crisis despite corporate leverage having generally increased. Quite the opposite is true of the spreads on bonds issued by banks, which tend to be multiples their 2007 marks. The major banks’ senior bond spreads are, for example, 8 times wider than their 2007 levels notwithstanding that the banks’ risk-weighted leverage has halved, their biggest funding source, deposits, is now government guaranteed, and their inherent liquidity risk has declined dramatically given they can tap very cheap emergency funding facilities via the RBA that were not available before the crisis.


Disclaimer: This information has been prepared by Smarter Money Investments Pty Ltd (ACN 153 555 867), which is authorised representative #000414337 of Coolabah Capital Institutional Investments Pty Ltd (AFSL 4822380 and an authorised representative #414337 of ExchangeIQ Advisory Group Pty Limited (AFSL 255016). It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. Past performance is not an indicator of nor assures any future returns or risks.



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