Tuesday 12 July 2016 by Jonathan Sheridan Opinion

Relative value suggestions for the coming year

Periodically over the last financial year we’ve discussed where value can be found during uncertain times. With several important situations that have impacted the “lower for longer” global markets, we look at what this means for investors

Greece

Unsurprisingly, Greece has been overshadowed completely by Brexit. When this was a problem, the real risk was in contagion spreading to the other teetering southern European economies, with Italy in particular the major worry.  Britain’s decision to leave the EU has exposed the divides that exist with a shocking suddenness, and now Greece is a mere sideline to much bigger questions about the continuation of the European project.

US Fed and interest rates

The market pricing for the path of the Fed funds rate was always much flatter than the FOMC had predicted – and now we are seeing that come to pass. The St. Louis Fed President James Bullard has been a noted hawk on the policy committee – which means he has been in favour of raising rates.  In an extraordinary turn of events, he recently revised his models for the economy and became the most dovish member of the Board, expecting only one rate hike in the next two years.

It seems like the US have stopped at one hike. This doesn’t paint a rosy picture for growth, as it implies that the Fed lacks confidence in the US economy improving enough to handle a rate rise.


Source: Bloomberg

You can see the market pricing in the purple line, and Bullard’s new dots around the same place.  A year ago, the median dot for January 2017 was 2.5% – now it is 1.60%.

RBA and locally

Following on from the May 2015 rate cut to 2.0%, the RBA again cut rates this year to the current 1.75% – with many commentators seeing at least one or two more cuts before the end of the year.  We think there is the potential for one, but only in the event of a poor inflation print at the end of this month ahead of the August meeting.  The last cut confirmed that the RBA are an inflation targeting central bank, so if we have no inflation, we should see lower rates.

Value in credit, not duration

We still hold to this view.  Long rates have come down a lot; a year ago the Australian 10 year government bond was at 3.07% and now it is 1.94%. If you were invested in the government bond, you would have made a strong return – over 8% – but even with rates low and looking like going lower, you can’t rely on the macro environment to do all the work for you. However, income can be protected from a fall in market rates by selecting a diversified portfolio of higher yielding credit which pays good margins over base rates – and by that I mean upwards of 3.5%.

Examples where this has worked really well in recent times are Qantas and Glencore.  Of course it doesn’t always work – Newcastle Coal (NCIG) has been an underperformer but I am still a believer in this credit and with a 12.5% coupon just a short holding period will deliver you a positive return even if the capital price falls.

The chart below shows that the spread of BBB bonds at five years is now 260bps over the government bond, in comparison to 160bps in April 2015. So the benefits of investing in credit are even better than they were a year ago.

Beyond five years, the curve flattens – not offering much value for investors.


Source: Bloomberg

Lower for Longer

The “lower for longer” environment continues to hold true for both equity returns and bond yields. This is becoming firmer across the spectrum of investing.  The ASX200 was at 5,422 a year ago, and today sits at 5,367. Furthermore the dividend yield is around 4.7%, so assuming that has been received, over the last year the total return has been zero.

The beauty of bonds is that even if the capital price moves against you in the short term, holding to maturity – or some future point where a high income compensates – will deliver you a positive return as long as the company is solvent.

Other jurisdictions have bigger problems than us, and we are not talking economically.  Whilst the US and Australia’s 10 year bonds have just touched record low levels, at 1.377% and 1.91% respectively, the entire CHF government curve has hit negative yields:


Source: Bloomberg

Another example on the importance of credit – in an environment where governments can borrow money for any term and be paid to do so – is a recent US primary issue from the global brewer Coors Molson, who raised US5.3bn from a four part deal.  The US1.8bn 30 year tranche paid 4.23% fixed.  They also did an €800m EUR issue which paid 1.29%.

So, while our yields may seem low, there is still a lot to be thankful for.

Summary

We think the principles still hold true to what was written a year ago.  Hold a well diversified portfolio of bonds, with an ‘anchor’ of investment grade which seeks to favour risk and opportunity where it has the potential to be well rewarded.

There are investment grade yields available for five year periods in the 4 to 5% region and plenty of opportunity in high yield, both in AUD between 6 to 8% and in USD between 6 to 11%.

We think GBP will offer a lot of value at some stage, but we would rather see a sustained bottom in the GBP before opening positions. Whilst we think Fed rate hikes are unlikely, with perhaps one to go this year if employment numbers continue to remain strong coupled with wage growth, we are of the view that the AUD has a final range of about 65 to 70c.

There’s still much to think about – it feels a lot like the post Lehman 2008; the calm before the storm. Italian banks are trading at 10% of book values; there are more referenda to come in the EU next year; and yield curves are flattening. This adds up to a lot of uncertainty and not an environment in which we suggest having a large holding of assets that aren’t obligated to pay investors. Consider investing in fixed income assets such as bonds, which provide certainty of income, attractive yields, and act as a reliable alternative in a “lower for longer” environment.

Investment grade bonds

Company Call date Maturity date Bond type Yield to maturity Running yield Capital price Face value Capital value
Glencore Australia
19/09/2019 Fixed 5.19% 4.59% 98.000 $10,000
$9,800
ME Bank 29/08/2019 29/08/2024 Floating  4.56%  4.69% 99.831 $10,000
$9,983
Praeco 28/07/2020 28/07/2022 Fixed  4.11% 6.41% 111.200 $10,000
$11,120
Suncorp Subsidiary, AAI 18/11/2020 18/11/2040 Floating 4.45% 5.13% 103.151 $10,000 $10,315
Sydney Airport Finance
20/11/2020 CIB 5.25%  3.61% 141.145 $13,560 $14,115

Bonds listed are in AUD
Available to wholesale investors only
Note: Prices accurate as of 12 July 2016 but subject to change; indicative only


High yield bonds

Company Maturity date Bond type Yield to maturity Running yield Capital price Face value Capital value
Adani Abbot Point 29/05/2020 Fixed
8.48% 7.43%
95.500 $10,000
$9,550
Aviation Training Investments
13/11/2020 Fixed 6.93%
7.35%
102.100 $10,000
$10,210
Cash Converters International 19/09/2018 Fixed
6.91%
7.79%
102.050 $10,000
$10,205
G8 Education 07/08/2019 Fixed
6.55%
7.43%
103.000 $10,000 $10,300
SCT Logistics 24/06/2021 Fixed
6.41%
7.27% 105.200 $10,000
$10,520
Impact Group 12/02/2021 Fixed
8.02% 8.38% 101.450 $10,000
$10,145

Bonds listed are in AUD
Available to wholesale investors only
Note: Prices accurate as of 12 July 2016 but subject to change; indicative only


USD denominated bonds

Company Maturity date Bond type Yield to maturity Running yield Capital price Face value Capital value
Fortescue Metals Group 01/04/2022 Fixed
7.04% 6.93% 99.250 $10,000
$9,925
Newcastle Coal Infrastructure Group
31/03/2027 Fixed 11.42% 11.73% 106.536 $100,000
$106,536
Virgin Australia 15/11/2019 Fixed
6.68% 8.07% 105.350 $10,000
$10,535
Bonds listed are in USD
Available to wholesale investors only
Note: Prices accurate as of 12 July 2016 but subject to change; indicative only

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