Cut your reading time and listen to a podcast instead. This week's BondCast looks at US interest rates, Barminco and NCIG
Learn more about what bonds are on the move with this weekly podcast. We are joined by our senior relationship managers to discuss US interest rate expectations and our thoughts around investing in Australian longer dated USD high yield. We look at two bonds - Barminco and Newcastle Coal Investment Group. See the transcript below on the page.
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Director, Fixed Income Sales
Jake grew up in Ottawa, Canada, where he rose from a teenage bank teller to a portfolio manager overseeing more than $600 million in assets for the Bank of Nova Scotia. With over twenty years in asset management he moved to Australia seven years ago with his family.
Director – Education and Research
Elizabeth has been with FIIG for ten years and for much of that time has been a corporate and bank analyst. In recent years her passion for education has seen her role shift, to author/ edit FIIG’s “The Australian Guide to Fixed Income” and an online fixed income course for Financial Advisers. She continues to edit FIIG’s weekly newsletter, “The WIRE”.
In her role as Director of Education, Elizabeth has delivered presentations at conferences across Australia. Prior to joining FIIG, Elizabeth worked as an Editor/Analyst for Rapid Ratings, writing daily press releases for Bloomberg. Elizabeth spent five years in London, three working as a credit rating analyst for NatWest Markets.
Director – Fixed Income
Stephen Mackie is based in the firm's Brisbane office, managing investments for clients, ranging from individuals to institutions.
Stephen has over 25 years' experience in global markets, including his most recent role at QIC where he was a Director - Investment Specialist in the Global Multi-Asset team. Prior to this, he has held a variety of senior roles as a trader and portfolio manager with RBC Capital Markets, Citi, Kapstream Capital and the Commonwealth Bank.
[00:00:00] Elizabeth Moran: Hello, welcome to another edition of BondCast. My name is Liz Moran. I'm director of Education and Research here at FIIG and today I have with me Jake Koundakjian and Stephen Mackie.
[00:00:11] Both: Hey Liz.
[00:00:11] Elizabeth Moran: How are you both?
[00:00:12] Both: Yeah, great.
[00:00:13] Elizabeth Moran: So today we're going to talk about interest rates and the Fed, the 10 year US government bond yield and the curve and then we're going to talk a bit about some Australian companies issuing US dollars and why we now think they're pretty good relative value. Steven perhaps you'd like to kick off with a bit of a discussion about US interest rates?
[00:00:34] Stephen Mackie: Sure Liz. So I think when we're talking about bonds we've got to be aware that there's a risk that sits with holding a bond, particularly a fixed rate bond. Obviously if interest rates rise then your bond prices will fall. And generally most US bonds have what's known as duration risk. So, as bond investors we need to be acutely aware of what causes these interest rate rises. Foremost amongst them is the US Federal Reserve, who has done a pretty good job over the past 10 or so years since the crisis in graphing the market. This is to the point where they actually have a plot chart where they put dots on a chart and actually tell investors where they're expecting to move the main overnight borrowing rate, the Fed funds rate, to at any given point in time. So you know for bond investors this is pretty good. It means that we know where our risks lie.
[00:01:30] Stephen Mackie: You'll hear in the market on that business report in the news that people will talk about what's priced in. Over the next 12 months from the US Federal Reserve we've got about 70 basis points worth of hikes, so that's almost three 25 basis point hikes. And then after that we've only got about 10 basis points in the year after. So over the next two years you're looking at about 80 basis points, give or take, of interest rate hikes. Now I think for investors you need to take that into account because should the Fed not do that, should they not hike as aggressively and you buy a fixed rate bond, your bond will do better because the bond has factored that into it. So the bond has got the Federal Reserve hikes priced in. So that's a very important phrase for bond investors to remember - "priced in". There is, of course, the risk that inflation picks up and the Fed has to act a little bit more preemptively to reduce inflation expectations. And they may hike more than the three to four that are priced in, in which case your bonds will fall. But I think just the big takeaway for me is to make sure investors are aware that you can look into the future as a bond investor and you can see what the market has got priced in and make your own assessments based on your own view on what global growth is doing, what inflation is doing. So we are all in touch with inflation. We can see that prices go up and down and the cost of imported goods in Australia can fluctuate with the Aussie dollar as well.
[00:03:02] Stephen Mackie: So I think as investors we just need to be aware of what inflation is doing and what that means for monetary policy and particularly for the US Federal Reserve monetary policy.
[00:03:12] Elizabeth Moran: So I think they're fantastic points, Steven, really good that we go back and just touch on those again. That's really part of why FIIG Research have been saying short in duration - prefer floating rate bonds over longer dated fixed rate bonds. But what we've seen just very recently with the Fed hikes, you know they've gone up, but the longer dated 10 year govies haven't so much, is that right?
[00:03:37] Stephen Mackie: Exactly. So if we look back in history, say more recent history of the past 25 years, the Fed funds rate never got higher in a hiking cycle than the 10 year bond rate has peaked. So we've had a peak in the 10 year bond rate of about 3.2%. Now if we look at where that Fed funds rate is priced forward in time, it doesn't go higher than 3.2%. So if we look back in history, and again it's no determination of future interest rates, but that 10 year bond rate that we're looking up at the moment is basically made up of where the cash rate is going to be every single day over the next 10 years. And as far as the market's concerned that 10 year Fed funds rate doesn't clear 3.2% at any stage in the future. So I think that's important just to understand that the entire US bond market is putting some parameters around the Fed and where they see future inflation going.
[00:04:33] Jake Koundakjian: Yeah well I guess I like to keep it simple. You know back in January of 2018, we're recording late July 2018, but back in January 2018 the whole world was saying "worldwide synchronized growth". Now to keep it simple. Interest rates go up because the glass is half full. Interest rates go down because the glass is half empty. The beginning of the year of 2018, everyone was singing from the hilltops "worldwide synchronous growth". So everyone was saying the growth is going to be prevalent which would put inflation on the table and therefore rates should go up. Here we are in July and that growth bang that was supposed to occur is kind of whimpering out a little bit, thus far, and we're seeing the US 10 year that was headed towards that 3.2%, still at about 2.8% or 2.9%, so still kind of whimpering along and actually July has been one of the lowest volatility months for the US 10 year for a long, long time. So I guess I like to keep it simple. The psychology earlier in the year was much more that growth was going to be prevalent and therefore rates should be rising aggressively. Certainly if rates do climb as is projected by the DOT blogs and what's expected, you could have a shorter end that's higher than the longer end of the curve. Hard to know and hard to predict.
[00:05:44] Stephen Mackie: Exactly. Yes, it is. It's a hard one to predict but I think as investors in bonds, just as we do with equities, we've got to have some sort of framework that we're working within. So if you go back to looking at what's priced in and if that kind of sits with your expectations, then I think we can make rational decisions about which bonds with duration we're willing to invest in.
[00:06:10] Elizabeth Moran: And that's where we're starting to look at some of the Australian names that are issuing in US dollars and some of the opportunities there really in that market. They've been cheaper than they have been for a long time and we still fundamentally think the companies are good with even now better relative value. So let's talk a little bit about Barminco.
[00:06:30] Jake Koundakjian: So we talked about interest rates and how they've been on the rise but a company like Barminco or other credits, any companies, it's not just the interest rate risk - it's credit risk. You're being paid for taking the risk of the company. So we spent a lot of time, the research team spends a lot of time assessing, are we being paid enough for the risk we're taking? With Barminco, there's a company that started late 80s and is private debt owned. They're in the underground hard rock mining space. So, certainly cyclical in nature. About 60 percent gold and 20 percent nickel and a few others...
[00:07:05] Elizabeth Moran: They do diamonds as well, don't they?
[00:07:06] Jake Koundakjian: Yeah a little bit. It's mostly gold and nickel. That's their biggest exposure by about 80 percent. They get about 85 percent of their revenues from Australia. So, not a large international exposure, mostly Australia centric. They do have a strong market position. These guys and girls are out there helping miners dig up the gold and nickel and other commodities and trying to get it out of the ground and make profits for companies like Goldfields or Anglo Gold or Sirius.
[00:07:34] Jake Koundakjian: They're just out there helping companies. So currently, at the current price that the bonds drop down to, it has dropped three or four dollars I guess in the last four months or so. So certainly that may be from an equity standpoint, you know three or four per cent drops, probably every day. But in the bond space that means that I'm buying my bonds at better pricing for my clients. So I'm offering about 7.7%. This is a US dollar senior secured May 2022 fixed pay, so 2022 is not that far away.
[00:07:57] Elizabeth Moran: And it's rated B, is that right?
[00:08:08] Jake Koundakjian: That's right.
[00:08:08] Elizabeth Moran: So it is a fairly high risk bond, and of course there is currency risk. So there are a few risks to consider but we do on balance like that bond. Do you favour it?
[00:08:21] Jake Koundakjian: Yeah look there is certainly a risk, it's mining services. This is a very cyclical type of business and the mining exposure would probably be your number one concern. They are also highly levered. They do have good liquidity but 60 million of cash on hand and 75 million in lines of credit that are available to them, so, there are positives and negatives but we feel that 7.7% for a May 2022 at a fixed coupon of 96.5 or 97 dollars - this thing will mature in a few years’ time at 100, assuming everything goes fine. There's also a positive I like about them. They were listed a few years back and the private equity holders might want to relist the shares which would be quite positive for the bond holders. And there's also been rumours that Ausdrill might take a swipe at them. They have joint ventures together in Africa.
[00:09:15] Elizabeth Moran: It's always a good way to get to know another company, a joint venture, isn't it! And so another one we've favored over many years and this has been one of our top holdings over many years as well, top US dollar investment, Newcastle Coal Investment Group.
[00:09:32] Jake Koundakjian: Yes, I'll touch briefly on that. Newcastle Coal, it's been one we've been quite attracted to for a number of years. It's, as the name implies, in the coal space. So again, in that cyclical kind of area. These guys are owned by BHP and Yancoal, Whitehaven, Peabody and Centennial. So these are the guys, the companies that own this structure. These guys ship out up to 66 million metric tons of very, very high quality coal. There's two bonds that we trade now. There is a B+ rated one that's offered at about 8.1%pa. Very high coupon, 12.5%. That has been quite favored but unfortunately minimum investment is USD100,000. There is also a senior secure BBB rated line that was issued probably about eight or nine months ago. That's offered a little bit above 5% for a 2027 maturity. It's a higher quality and hence lower return. But yeah I do like the creditor and the coal is certainly well demanded out of Korea, Japan, Taiwan and Southern Greater China.
[00:10:35] Elizabeth Moran: I think Japan and South Korea are its biggest markets, so fairly stable developed countries as well.
[00:10:41] Jake Koundakjian: Yeah, the Japanese demand for that good quality coal that they ship out of that region of NSW, the Hunter Valley is very well demanded and you can see it through the commodity prices. There are a couple contracts that I follow pretty closely. And those are two or three of your highest priced contracts.
[00:10:58] Elizabeth Moran: So that's summarises today with longer term interest rates expected not to increase as much as we originally thought. We like some of the high yield Australian US dollar names. That concludes today's BondCast. If you have any questions or any comments or feedback please let us know. Thanks very much for joining us.