Well, it has certainly been an interesting year in markets.
We started in July 2018 with the US 10 year yield trying to break and hold above 3% - a level that seems pretty unthinkable now – but at the time all the talk was of the end of the 30 year bull run in bonds and how inflation was finally going to kick in.
The US-China trade war was just a border skirmish, and the AUDUSD rate was hovering around 0.74, having come down 2.5% from the highs in June alone. It has certainly shown its volatility over the last 12 months.
The shine was beginning to come off tech as a sector, although we would have to wait until late October/November for that sector to finally run out of steam. The Bloomberg FANG+ index has returned -9.38% in the last 12 months, as below.
Source: Bloomberg
One fascinating aspect of the calendar year 2018 was that in this slightly strange environment where we are in an “everything rally”, December saw risk assets finally correct a little, while defensive government bonds continued their rally, albeit mainly reversing their fall earlier in the year.
Overall, for 2018, only cash (looking at single asset classes) returned a positive number for the whole year. Amazing!
High yield credit spreads (the extra yield you get for taking credit risk over and above a risk free government bond of the same maturity) widened by 100bps just in December.
Risk assets have made a comeback in the first half of calendar year 2019, with the S&P500 breaking the 3,000 mark and making many all-time highs. The ASX200 is also closing in on its all-time high of 6,828 from 1 November 2007 – it’s only taken nearly 12 years to get there…
The pre-Christmas performance of the US stock market seemed to spook the Federal Reserve, and in early 2019 Jerome Powell made a huge about-face and began talking about rate cuts rather than hikes, which had been on the agenda as little as 3 months previously!! Equities took off and haven’t looked back, and credit has rallied as well, retracing all of that 100bp sell off.
I have remained pretty bearish throughout, and actually extended the high quality duration of the portfolio in January, looking to take advantage of falling long rates.
The market didn’t disappoint me, with the Australian 10 year rate falling around 130bps over the course of the year, ending at around 1.4%. The whole yield curve was actually briefly inverted until RBA Governor Philip Lowe came to Powell’s party and delivered 2 rate cuts, bringing the cash rate to a new record low of 1%.
Source: Bloomberg
The AUD/USD exchange rate also moved from 0.74 at the start of the year to 0.70 at the end, clearly benefiting the USD positions. With the spread between 10 year rates widening (as above), this was expected.
So, we sit at the end of the year with ultra-low rates, but inflation and wage growth almost non-existent, housing seemingly having bottomed after a 15-20% correction, and an uncertain trajectory. How did the portfolio navigate these times?
Trading wrap
The story of the year was one of taking opportunities in primary issues, and managing risk in other positions, against the back drop of falling rates.
This meant increasing the duration (as mentioned above), and rotating capital in new FIIG originated high yield issues.
The broader market threw up some cheap new issues, but these were often foreign banks, and as such legally restricted to $500k minimum parcels. Despite the value on offer, I have to stick to the rules (unlike others in the market) and so was unable to take advantage. I should have bought Incitec Pivot and AT&T, but at the time thought there was better value around – I will learn to sometimes suspend disbelief and go with the flow when a market is in this much demand for new bonds.
Investment Grade
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I switched the 2022 maturity ACG into the QTC 2033 for the duration extension, which worked out – a 26.4% gain for the 5 months I owned it – equivalent to about 11% for a full year.
The new AMP bond looked cheap despite their issues, so I switched from AAI 2022c and Seek, adding about 80bps of margin for a similarly rated bond. I also switched from the DBCT 2021 to the new Liberty 2022 FRN, adding over 100bps of margin there, and from the Transurban 2024 to the new NAB tier 2, just picking up 40bps without extending maturity, although I did move from senior debt to subordinated.
High Yield
The majority of the trading was focused on the sub investment grade and unrated sector.
Here risk management and capital preservation were the key themes.
I exited JC Penney, despite it being secured, as I didn’t like the trajectory of the results. I held Rackspace and Bristow despite their underperformance. Bristow ended up filing for Chapter 11 but the bonds, after initially selling off, recovered to near par, where I will sell in July. Rackspace also recovered to the low 90s, and I expect them to be fine. As usual I am monitoring closely…
I rotated into and out of Virgin positions in both USD and AUD, realising good capital gains along the way on all the different bonds. The AUD bonds have continued to rally to about 106, so I was a little early on exiting those. I also bought and sold Maurice Blackburn, and ended up in Armour Energy at year end, which I will rotate out of again when the next attractive fixed rate deal comes along.
Finally, in a large USD move, I sold some smaller positions to take up the NCIG junior bond once more. It has come off from its highs around 128, and I picked it up at 121.60. That was also a little early as it has settled around 119, but the 9% yield and 12.5% coupon are just too good to pass up. In a year’s time that will have more than made up for being a little early!
Overall return
The portfolio as a whole has returned 8.38% for the year, net of all trading costs. Given I lost on JC Penney and had negative mark to market on Bristow and Rackspace, this is a great result.
Remember the initial proposition was to maintain a 5% yield to maturity, and also preserve capital. For a portfolio 1/3 in government bonds and overall 69% investment grade, this shows how selective trading, some currency exposure and a reasonable allocation to high yield – in short a properly diversified portfolio – can produce excellent results.
