Tuesday 09 May 2017 by Guest Contributor Trade opportunities

What the sales team are trading

We are very excited to introduce a new WIRE series, taking a closer look at what our experienced staff are recommending and trading. This week, we feature trading ideas from Darryl Bruce, Western Australian state manager, Michael Cooper, Melbourne based fixed income sales director and a general idea regarding an ongoing theme to shorter duration

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Darryl Bruce – State Manager, WA

darryl bruce When I started at FIIG in early 2014 it was immediately obvious to me that the high conviction trade of the moment was to buy Qantas bonds. I had previously been wary of investing in airlines, however Qantas’ liquidity, and its status as a ‘national champion’ issuer combined with the high yields on offer made it look interesting.

At the time, Qantas had three bonds in the market maturing in 2020, 2021 and 2022 respectively. They have subsequently added some additional longer dated bonds, however it is interesting to look back and remember that in 2014 Qantas was deemed to be a relatively high risk investment opportunity – the yields reflected that. Obviously if we roll forward to today we know that Qantas has performed very well, due in part to a sharp fall in oil prices. This strong performance has been reflected in the bonds’ movement, with yields moving sharply lower and prices sharply higher as in the below charts. 








Source: FIIG Securities


Source: FIIG Securities

We now have very few concerns about Qantas from a credit risk point of view, but from a valuation perspective I think Qantas bonds are starting to look stretched. Each bond is trading well above par – a capital price of $100 – however when considering valuation I always focus on the yield to maturity rather than the capital price.

Any investor who got in early will be sitting on double digit annualised gains, although  the current yield to maturity across all three Qantas bonds is less than 4.0%. To me it is clear that the best part of the journey in these bonds is behind investors and I firmly believe that there are better alternatives elsewhere in the market. The fact that the capital prices are all well above $100 should allow many investors to lock in healthy capital gains before the bonds inevitably start tracking back to par as they near maturity. 

So, where to reinvest?

Qantas is a rated bond and as such it makes sense to replace it with another rated bond. This ensures that the credit quality of the overall portfolio is maintained. For investors who believe that the next interest rate movement will be higher it might also make sense to consider replacing the Qantas fixed rate with a floating rate note. I have listed some potential candidates for reinvestment below. All, with the exception of Alumina, are rated the same or stronger than Qantas and offer higher yields to maturity. 

Issuer Call/maturity date Bond type Capital structure Yield to worst Running yield Capital price 
Alumina 19/11/2019 Fixed Senior debt 4.41% 5.26% 104.500
Bendigo and Adelaide Bank 09/12/2021 Floating Tier 2 4.11% 4.39% 104.664
MyState Bank 14/08/2020 Floating Tier 2 4.92% 6.36% 106.590
Suncorp subsidiary, AAI 06/10/2022 Floating Tier 2 4.30% 4.67% 106.767
Sun Group Finance 16/12/2024 Floating Senior debt 4.33% 3.74% 102.842
Sydney Airport 20/11/2020 Inflation linked Senior debt 5.08% 3.62% 142.691
Sydney Airport 20/11/2030 Inflation linked Senior debt 5.81% 3.19% 126.088
Source: FIIG Securities
Accurate as at 9 May 2017 but subject to change
Red = wholesale; black = retail

You could also make an argument for replacing Qantas bonds with another high yield bond, given that Qantas was a high yield bond when it was purchased by many investors. 

Issuer Call/maturity date Bond type Capital structure Yield to worst Running yield Capital price 
Dicker Data 26/03/2020 Floating Senior debt 5.40% 6.03% 102.700
IMF Bentham 14/08/2020 Fixed Senior debt 5.99% 7.13% 103.650
SCT Logistics 24/06/2021 Fixed Senior debt 5.50% 7.15% 106.900
Source: FIIG Securities
Accurate as at 9 May 2017 but subject to change
Red = wholesale; black = retail

I think that investors holding Qantas bonds should give serious consideration to reallocating that capital more productively. Of course, neither of the lists are exhaustive – so if you are interested in locking in your returns from Qantas then please contact your dealer for more details. 

Darryl is based in the Perth office. He can be reached on (08) 9421 8502 or via email.

Michael Cooper – Director, Fixed Income Sales, VIC

michael cooper Last week, in his opinion piece in the WIRE Craig Swanger discussed that despite recent poorer than expected US economic data, the US economy is performing quite well. You can read about it hereExternal link - opens in a new window

Improved economic performance will lead to higher long dated USD bond rates as expectations adjust.  

In addition, unwinding of the US Fed’s QE program could involve the sale of US 30 year Treasury bonds that they purchased.  The sale will need to be managed very, very, carefully – otherwise there’s the risk that the supply causes a sharp steepening of the interest rate curve.

By steepening I mean short dated interest rates remain much where they are and longer dated rates rise, causing the slope of the term structure of interest rates to become more positive.

AUD interest rates do not trade in isolation, and any steepening in the USD interest rate curve will be accompanied by a steepening of our interest rate curve. Relative economic performance will determine how closely AUD rates track USD rates.

We know there is an inverse relationship between fixed rate bond prices and interest rates. If fixed rate bond rates move higher bond prices will fall, and vice versa. The longer a bond is in term, the higher the dollar value change per unit shift in interest rates.

For example, for a 1% shift higher in interest rates the Sydney Airport 2020 bond – which is inflation linked but pays a fixed rate over inflation, will fall by $2.36  Likewise, a 1% shift higher in interest rates will see the Sydney 2030 bond price fall by $8.03. Of course, the opposite is also true if interest rates move lower.

By switching from a long dated bond to a shorter dated bond prior to an interest rate curve steepening – and then switching longer again – an investor can outperform those that stay put in the longer dated bonds.

What a pity we don’t have perfect foresight!

Floating rate notes, of course, have almost no interest rate risk in this underlying sense. So switching to them would leave one further ahead in our example.

Part of my job is to highlight risks and opportunities and this is very likely both. I have been talking to investors about portfolio very long dated bond exposures in light of the potential risk.

For those who would like to switch from the longer dated Sydney Airport 2030 to the Sydney Airport 2020, indicative pricing is set out below.

Highlights of the opportunity:

  • Increase your running yield by 37 basis points or 0.37% per annum
  • Decrease your exposure (face value) by $13,000
  • Put an extra A$502.49 to work for you
  • Maintain exposure to the same issuer
  • CPI linked – providing protection against inflation
  • Shorten maturity profile by 10.0 years


Source: FIIG Securities
Accurate as at 4 May 2017 but subject to change

Michael is based in the Melbourne office. He can be reached on (03) 8668 8821 or via email.

A general consensus to shorten duration*

At the moment there’s an opportunity in the market to reduce duration risk – while increasing cashflow, yield and margin – by switching to a shorter dated bond.

Recently we DirectBonded a new USD 2022 bond from Talen Energy Supply. The new 2022 is similar in structure to the longer dated 2025 Talen bond – but due to the 2022’s recent origination, the 2025 bond now looks relatively expensive by comparison.

The graph below displays the Talen bonds on issue. Each dot in the graph represents a Talen bond. Yield is shown on the Y axis and term in years on the X axis. The curve drawn is a best fit curve.

Talen’s 2022 maturity, despite sitting shorter on the curve in term, is sitting at a higher return than Talen’s 2025 maturity. The credit rating for both bonds is the same. 


Source: Bloomberg, FIIG Securities

Switching shorter makes sense for a number of reasons:

  • Exposure to the issuer is the same
  • Duration is shorter
  • Market yield is higher
  • Credit margin is higher, and
  • Cashflow is higher.
  • Price volatility per unit shift in interest rates is lower

The below example shows how switching to a shorter dated bond works by selling $100,000 face value of the Talen 2025 bond and buying $84,000 face value of the shorter dated 2022 bond.

Despite taking less face value you still achieve a better internal rate of return on the 2025 proceeds, more income, and less duration risk.


Source: FIIG Securities
Accurate as at 8 May 2017 but subject to change


Glossary

Duration

Duration is a useful measure of risk in bond investment represented in years. Developed in 1938 by Fredric Macaulay, duration measures the number of years needed to recover the cost of the bond, taking into account the present value of all coupon payments and the principal payment received in the future. Bonds with higher duration typically carry more risk and thus have higher price volatility. For vanilla fixed rate bonds, duration is always less than time to maturity, for floating rate notes, duration is typically very short and based on the next coupon reset date.


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