Monday 21 November 2016 by Scott Whitecross Week in review

From the trading desk

The Aussie dollar is at its lowest level for six months and government bond yields continue to sell off

Economic Wrap

The continuing themes post the US election are: stronger USD, higher US yields, and a view that spending by the Trump administration will lead to higher inflation, which will be good for corporate profits and stocks.

In particular, this rise in government bond yields has led to recent media articles citing a rout in bonds and monies shifting into equities. Although it’s true that both US and Australian government bonds have sold off and managed funds will experience severe negative returns for November, it is not true of all bonds.

As a reminder, corporate bonds have a credit spread attached to them an additional yield over the government bond rate, meant to compensate for credit risk , whereas government bonds by definition have a zero credit spread. This is why we monitor credit spreads – and although some may struggle to understand the mechanics, we can all conceptualise that more credit worthy borrowers can borrow at lower levels than less credit worthy borrowers.

Bonds still have great importance in the investment decision, offering greater returns than deposits and being higher up the capital structure than equities. Portfolio wise, we suggest rebalancing post Trump’s win to being more equally weighted, with a one third exposure to each of fixed, floating rate and inflation bonds.    

US government bonds are higher in yield over the week, with the 10 year bond currently at 2.356%. Other major economy government yields are higher too. Notably, current 10 year Japanese government bonds are trading at a positive 0.04% yield – the first time in nine months they have been in positive territory. Further, 10 year German bunds are trading at positive 0.27% and 10 year UK government bonds (gilts) are trading at 1.45%.

Other news:

  • Stocks were lower on Friday. In Europe, the Eurostoxx was down 0.69% and the FTSE 100 was down 0.28%. In the US, the Dow Jones was down  0.19% and the  S&P500 was down 0.24%
  • US economic index (LEI) rose 0.1% in November versus 0.2% in October
  • German Chancellor Angela Merkel will run for a fourth term in office in 2017
  • China’s president Xi Jinping praised Barack Obama for strengthening ties between China and the US, and called for a smooth transition in the relationship between the two countries
  • UK Chancellor Philip Hammond said Britain has ‘eye wateringly large debt’ and that the economy is facing a sharp challenge

Credit indices spreads are broadly unchanged over the last week, with the US Investment Grade Index (IG) finishing Friday up 1 basis point (bps) at 76.75 bps, whilst the US High Yield Index (HY) narrowed 1.0 bps on the week to finish Friday at 416.0 bps.

Domestically, the 10 year Australian government bonds last traded at 2.72%, 6.5 bps higher on the week. The Australian iTraxx is at 113.05 bps (or 1.13% for this index of 25 Australian Investment Grade names), down 0.75 bps over the week.

The Aussie dollar is trading at 0.7320 today, as USD strength pushes down our currency from 0.7550 one week ago.

The USD has appreciated more significantly against other currencies, notably the Yen. Markets are pricing a 70% upwards chance of a US rate rise at the Fed meeting in December.

As we noted in last week’s trading desk, higher yields on government bonds will lead to more evenly balanced portfolios split across fixed rate, floating rate and inflation linked bonds. Importantly, the vast majority of the fixed rate bonds we use are shorter dated being five years and less and consequently are less exposed to duration risk.

Flows

Supply in a number of FIIG originated bonds became available late last week, spurred by a new issue coming to market. Adani 2020s, Capitol Health 2020, CML Group Ltd 2021 and Impact Group 2021 are in decent volume, with each of these issues available in minimum investments of $10,000.

They are currently indicatively offered at the following yield to worst:

  • Adani fixed rate May 2020 at 6.86%*
  • Capitol Health fixed rate May 2020 at 7.27%* (available to wholesale clients only)
  • CML Group fixed rate March 2021 at 6.34%* (available to wholesale clients only)
  • Impact Group fixed rate February 2021 at 7.95%* (available to wholesale clients only)

The recent appreciation in the price of iron ore, coupled with significantly strengthened cashflow, has seen many holders of the Fortescue senior secured and unsecured notes take profits by selling into an attractive street bid. The Genworth 7.625% September 2021 has been a popular switch target for clients wishing to stay in USD. Genworth remains in good supply and is offered at an indicative yield to maturity of 8.92%. The October 2020 bond from Canadian gold miner IAMGOLD Corporation has also been a focus for investors wishing to remain exposed to the resources sector. IAMGOLD is available at an indicative yield to maturity of 6.63%.

*In this instance, yield to worst and yield to maturity are the same. The yield to worst (YTW) is the lowest yield an investor can expect when investing in a callable bond. A note explaining the different types of yield can be found here.External link - opens in a new window

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