Wednesday 08 January 2020 by Asmita Kulkarni General

Reflecting on 2019

In this article we take a look at events that affected Australian bond investors over 2019 and reflect on the good, the bad and the ugly.

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Background

The majority of the events that we considered at the beginning of 2019 as being likely to occur played through as expected. Geopolitical risks such as US-China trade discussions, other US trade negotiations and Brexit dominated headlines. What did surprise though, was the dovish stance taken by global central banks.

We started 2019 with fairly hawkish central banks but finished the year with rate cuts in both the US and Australia. The year also kicked off with heightened market jitters following the sell-off of late 2018 but most risk assets posted strong positive returns by year end. Charts 1 & 2 below show how high yield bonds, investment grade bonds and equities in AUD and USD performed over the course of 2019.

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The good, the bad and the ugly

People have a tendency to recall prior negative experiences rather than the positive ones. It is called “negativity bias”. This also applies to investing and investor recollections. While there were a number of events that were negative for bond investors during 2019, it wasn’t really all that bad (as the charts above show). Below we take a look at a handful of events from 2019 and consider whether they were good, bad, ugly or somewhere in between.

Geopolitical tensions – mostly bad but markets showing signs of resilience

Trade tensions and Brexit negotiations continue to weigh on market sentiment and business confidence. Among the disputes are trade negotiations between the US and China; the US, Mexico and Canada; as well as the US and certain European economies such as Italy and more recently France. Seems to be a bit of a theme here. 

Generally speaking though, the US economy remained mostly resilient to these pressures (aided by central bank intervention) and recession risks in 2020 are starting to subside (Chart 3), though weak manufacturing and pressure on the utilities sector are risks worth monitoring. The same can’t be said for European economies, which continue to navigate negative interest rates. 

Domestically, business and consumer sentiment is weak and despite wealth creation through property and equity price appreciation, the lack of income (wages) growth is keeping inflation subdued.

Global economic policy uncertainty remains high and what is masked in the chart below (Chart 4) is the fact that policy uncertainty in Asia is quite high due to trade tensions. 

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Policy rates –good for borrowers, bad for investors

We started 2019 with a hawkish Fed and RBA, only to finish with multiple rate cuts from both central banks. The US and Australia weren’t alone in this downward move. By the end of September 2019, sixty central banks from around the world had cut policy rates over 110 times, rolling back the effects of any rate hikes enacted in 2018. 

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Over the course of the year market participants and the media increasingly discussed quantitative easing (QE) and the implications of negative yield curves. Domestically, the RBA has made it abundantly clear that it is open to unconventional monetary policies such as QE should it be required. 

The central banks have been pre-empting an economic slowdown and the looser policy is aimed at kick starting slowing or stalling economies, easing the servicing burden on borrowers, which is the good. However, this has also meant that investors are now having to take on additional risk as returns from traditional investments such as term deposits are not sufficient to meet their income needs.

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Corporate Defaults – ugly, but manageable within a diversified portfolio

While bond price performance in 2019 was strong, there were pockets of weaknesses driven by idiosyncratic (company specific) risk. However, in most of these cases investors did not lose all their invested amounts as coupons and a final workout amount accounted towards a reasonable return on investment. 

It is worth putting this in context, remembering that FIIG clients have exposure to over 500 various bonds, many of which experienced strong capital gains in 2019. For example, in AUD the Zenith 2025 maturity bond price increased by 4.90% from AUD102.10 at the beginning of the year to AUD107.10 now, for an annual total return of 12.29%. Similarly, in USD the Adani 2022 bond price has moved up 14.73% since the beginning of the year, for an annual total return of 19.77%. 

To name a few others, Sydney Airport 2030 ILB, NCIG Group 2027c, QBE 2026c, Westpac 2023c and 2026c, Incitec Pivot 2026, Pacific National 2025 and 2027, AT&T 2028, and GPT 2026 bonds have all returned over 8% in 2019.

As can be seen with the names listed above, investors with well diversified portfolios were cushioned from lagging individual bond performance as the other holdings in their portfolios provided a buffer against one or two poorly performing bonds. Furthermore, high yield bonds generally pay higher coupons and this provides a further buffer against downward capital price movement. 

As noted above, this year has seen many bonds experience stellar price movement. Investors should take a look at our model portfolios as a guide to portfolio diversification.

Bond issuance – a good opportunity to diversify into a wider variety of bonds

Lower global interest rates have resulted in higher bond issuance levels as borrowers take advantage of cheaper funding. The 2019 global corporate bond issuance was close to USD13tn (Chart 7). We would expect this issuance trend to continue into 2020. 

This frenzy in issuance has been aided by not only lower interest rates but also relatively low credit spreads, resulting in lower overall funding costs for a corporate borrower. Both investment grade and high yield credit spreads have moved lower in 2019 following the spread blowout of 4Q 2018 (Chart 8). 

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As more and more new and existing issuers come to the market, investors have the opportunity to consider a wider variety of transactions that suit their investment mandates. We believe bond structures will also evolve as issuance increases and we are already seeing exciting developments in the floating rate space with Libor getting phased out by the end of 2020 and the Australian BBSW likely to follow suit shortly after.

In 2019, along with a number of FIIG originated bonds by Armour, zipMoney, SCT, WorkPac, VisionFund, Sunland, Stockwell, Elanor Wildlife Park and IMF, FIIG clients were also able to access a large number of public market transactions issued by Virgin, Ford, SEEK, Origin, GPT, Dexus, Qantas, Pacific National, David Jones and Verizon.

Property prices/RMBS – good, strong rebound in Sydney and Melbourne

At the beginning of 2019 we were staring into the abyss as property prices in Sydney and Melbourne continued to decline, however a combination of the APRA serviceability rule changes, the Coalition election victory and mortgage rate cuts stalled this downward trend (Chart 9). 

Throughout this period, we continued to suggest that clients should consider residential mortgage backed securities (RMBS) as an investment option because a lot more than just property prices impact these securities. RMBS offer strong yields, which are often higher than an equivalent rated corporate bond. In the second half of 2019, there was a strong demand for Australian RMBS from both domestic and offshore issuers, which resulted in 2019 being one of the strongest years of public RMBS (excluding private deals) issuance since 2007 (Chart 10). 

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Conclusion

As we enter 2020, we continue to believe we are in a late cycle rally. Increasingly there are signs of a credit correction likely to occur in the medium term fuelled by cheap availability of credit.  We do not expect investment returns in 2020 to be as strong as they were in 2019. This means that rather than chasing yield, it is more important than ever to assess credit quality of investments and diversifying holdings in a portfolio.

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