In the AFR today I examine whether Aussie corporate and financial bonds are currently cheap or expensive relative to pre-GFC and post-GFC spread levels, on the basis of bottom-up modelling of their fundamentals, and compared to US investment-grade and high-yield credit (click on that link to read for free or AFR subs can use the direct link here). Excerpt below:
"While Australian savers are being crucified by a rare negative "real" cash rate (inflation is running at about 2 per cent), credit spreads on financial bonds are actually far higher than they were before the global financial crisis even though these institutions are safer today than they were a decade ago. Put differently, whereas price/earnings multiples for Australian and US equities, commercial property and residential housing are more elevated than they were in 2007 – implying these asset classes are dearer than they have been before – spreads on financial bonds are cheap judged against the same pre-GFC thresholds. Back in 2007, the major banks were issuing five-year senior floating-rate notes (FRNs) on spreads of around 10 basis points (0.10 per cent) above the prevailing three-month bank bill swap rate (BBSW), which is a proxy for the cash rate. This BBSW rate is actually 1.7 per cent, or a smidgen above the cash rate, because the majors' bank bills carry residual credit risk. So despite the fact that the ratio of these banks' equity buffers relative to their risk-weighted assets is some 2.2 times better than their 2007 levels, they have been forced to issue senior FRNs at spreads that are 10 times wider than those required a decade ago. (I own these assets in my portfolios.) A similar, although less enticing, story applies to non-financial corporate debt. According to the RBA, the average credit spread for A rated (BBB rated) Aussie corporate bonds with a five-year maturity was 27 (55) basis points in early 2007. Today A rated (BBB rated) corporate spreads are 74 basis points (111 basis points), or more than twice their pre-GFC levels. While financial and corporate bond spreads look attractive compared to pre-crisis marks, this is not true if you judge them only on the basis of the spreads that have been required in the post-crisis years. Since 2008 the average A rated (BBB rated) five-year corporate spread has been 126 (228) basis points, roughly double current spreads. Financial spreads are likewise tighter today than their post-GFC averages. This begs the question whether the credit risk pricing regime before or after the crisis is correct, or whether we are entering a new regime that book-ends these epochs. If spreads were too tight before the crisis and have on occasion pushed excessively wide since, a middle ground might assert itself. This just happens to be the contemporary local spread narrative. And while spreads will doubtless experience headwinds from the unwinding of central bank asset purchases, or "quantitative tapering", risk appetites should benefit from the synchronised upswing in global growth until such a time as the cost of capital effect dominates. These observations do not necessarily apply in countries where the impact of central bank purchases has been more immediate. In the US, for example, credit looks expensive on most metrics. In the US investment-grade sector, which covers bonds rated BBB- or better, spreads have tightened to around their pre-GFC levels (and "inside" their average spread between 1996 and 2007 according to Merrill Lynch data). Sub-investment grade, or "high-yield", spreads are also below pre-GFC averages, although 100 basis points wide of 2007 tights. One of my favourite trades since the December 2016 budget drama and related credit rating uncertainty has been buying the major banks' senior-ranking FRNs with five-year maturities, which were being offered on spreads as wide as 110 basis points or more. Today these securities are bid 30 to 40 basis points tighter and have, therefore, furnished significant capital gains as spreads mean-reverted back towards fair value, which we put around 60 basis points based on bottom-up modelling of expected losses." Read full article at AFR here.
Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.