We continue our new series, taking a closer look at what our experienced staff are recommending and trading. This week we feature trading ideas from sales directors Tom Guest and Ben Taylor, and head of portfolio strategies Leigh Winton
Tom Guest – Director, Fixed Income Sales, QLD
About a fortnight ago, credit ratings agency S&P lowered the credit ratings of 23 financial institutions. They stated the downgrades reflected developments in private sector debt and residential property prices – particularly Sydney and Melbourne – resulting in greater economic risk to the sector.
In short, hybrid and subdebt instruments issued by these institutions have been lowered by one notch.
It’s worth noting the subordinated bonds we trade here at FIIG have held up quite well in terms of price. But when these institutions return to raise additional capital in the market, it’s likely they will need to do so at a higher rate. It wouldn’t surprise me to see price weakness in the short to medium term.
What does this mean for the bank sub debt that you own? It’s a good time to assess your options, before these institutions come back to market.
You might be asking:
- Is it possible to sell now and secure a good result? YES
- Can I reinvest the funds and
- Improve my return? YES
- Maintain investment grade? YES
- Increase my position in the capital structure by moving to senior debt? YES
There is a security that allows you to do that. Around the same time as the S&P downgrades occurred, Liberty Financial launched a new three year senior bond. While they’re well known for RMBS issues, this isn’t one. It’s a plain vanilla, fixed rate, three year, senior corporate bond. It has no call dates and is rated investment grade.
To give you a bit of colour, Liberty is non bank lender that has been in operation since 1997, providing a wide range of loan products (notably mortgages, but also autos, personal, and business loans). In FY16, Liberty originated $2.5bn of loans, and are a niche lender with a strong position in the Australian marketplace. It is very well capitalised and management have stated their commitment to maintaining risk adjusted capital above 15%. In comparison, the big four banks maintain risk adjusted capital rations between 8-10%. Liberty’s shareholders contributed $25m of new equity to this end in FY16.
For those who would like to switch from the Members Equity Bank 2019 floating rate note sub debt to the Liberty 2020 fixed rate senior debt, indicative pricing is set out below. Note Members Equity Bank subordinated debt is available to retail and wholesale investors, whereas the Liberty bonds are for wholesale investors only.
Here’s some highlights of the trade:
- Increase your yield by 47 basis points or 0.47% per annum
- Improve your margin by 0.39%
- Increase your running yield by 0.58%
- Put an extra $219.50 to work for you
- Move from subordinated debt to senior debt
- Improve the credit rating on your investment
Source: FIIG Securities
Accurate as at 16 June 2017 but subject to change; indicative only
Tom is based in the Brisbane office. He can be reached on (07) 3231 6621 or at Tom.Guest@fiig.com.au.
Ben Taylor – Director, Fixed Income Sales, NSW
In a recent WIRE article written by our senior economist Craig Swanger, he asks “is data the new steel industry of the 21st century?” In it, he makes some very interesting observations about the growth in digital infrastructure – noting that demand for data storage is doubling every two years.
NEXTDC just completed a bond issue, that was very well received I might add! It’s a name that many investors will be familiar with, providing exposure to the digital infrastructure sector that’s showing solid growth.
To briefly recap, NEXTDC is an ASX200 business that designs, develops and operates data centers in Australia. They are currently the only independent data center operator with locations in Sydney, Melbourne, Brisbane, Perth and Canberra. NEXTDC commenced operations in 2010, listing on the ASX later that year. Its market capitalisation is currently ~$1.22bn.
The bonds pay a fixed coupon of 6.25% and will be called early or mature at a price of $101.50. This is as opposed to most fixed and floating rate bonds, which typically mature at $100. On this basis, you can assess these bonds on “yield to maturity” or “yield to worst” basis, indicative and accurate as of 15 June 2017.
Access to these bonds may be a little difficult and could take a while, however I do believe I will be able to find them, if you are interested and wish to join the queue please call.
Source: FIIG Securities
Accurate as at 16 June 2017 but subject to change; indicative only
Ben is based in the Sydney office. He can be reached on (02) 9697 8731 or at Ben.Taylor@fiig.com.au.
Leigh Winton – Head of Portfolio Strategies, NSW
The rally in US Treasuries (UST) has seen 10 and 30 year yields move down recently. The 10 year UST yields are now 2.17% from a high of 2.60% in February; likewise, the 30 year UST yields are 2.80% from a high of 3.21% in February.
Many of our clients are in the money on their TransAlta 2040 bond positions, and I believe this is a good time for clients to take profit.
Treasuries are still way off their lows of 1.36% for the 10 year in July 2016. I think the chances of revisiting these lows in yield are slim, as Trump looks to reinvigorate the US economy with potential tax cuts and infrastructure spending.
Interest rates are mean reverting. I expect rates in the US to start rising again, with a greater chance of seeing a rise in yields here rather than a decline. If yields do rise, we have a long held view that there could likely be a steepening of the yield curve, having a greater impact on the long end.
Therefore, even if the TransAlta credit story is performing, there is a good chance the bond price will be negatively impacted by any rise in overall US rates.
Duration is often not well understood, but we know that a 100 basis point change in yield for a longer dated 20 year bond is not the same as a 100 basis point change for a shorter bond. The price of the bond, relative to its change in yield, will have very different outcomes depending on its term.
We refer to duration as the percentage change in price of a bond for a 1% shift in interest rates. The duration for the TransAlta 2040 bond is 11.4, meaning that a 1% shift up in rates will cause a change in the bond price of approximately the same amount – a fall of 11.4%. The reverse is also true.
As such, I reiterate my preference for shorter maturity US bonds as they are less exposed to rising interest rates. The new Transocean bond is a better fit for clients who feel comfortable moving from an investment grade security to a sub investment grade one.
Indicative switch pricing from TransAlta to Transocean at Tier 2 levels is set out below.
Source: FIIG Securities
Accurate as at 16 June 2017 but subject to change; indicative only
Leigh is based in the Sydney office. He can be reached on (02) 9697 8759 or at Leigh.Winton@fiig.com.au.