Introduction
In the midst of a low growth environment, with zero real cash rates, the need for yield remains imperative for many investors. While our recent “road-show” on ILBs introduced the idea of inflation as the “third dimension” for portfolio construction, in addition to the typical dimension of risk and return. More specifically, this piece looks at the following specific questions:
- duration risk,
- reversion to “normal” yields,
- credit risk,
- the relative value of the Sydney Airport 2030 ILBs, in relation to other fixed income securities,
- the reasons for the credit ILBs being as cheap as they currently are, and
- why the Sydney Airport 2030 ILB should rally towards “par”, or 3.12%, during 2014.
Finally, we draw these various arguments together, as they specifically relate to the needs of investors.
Duration risk
Since ILBs have a long duration, many investors argue that the interest rate risk in these securities is excessive. However, the same investors typically hold equities that have an infinite length, in terms of dividend stream, where the pricing of that dividend stream varies wildly, according to perceptions of economic growth. In other words, most investors already have exposure to very long dated investments, such as equities, although those investments have a high volatility, relative to inflation. If one were to sum the total dividend duration of an equity, then one would end up with a very large number.
While the Sydney Airport 2030 ILB matures in about 17 years, most investors will live well past this date, and improved longevity tends to suggest that even the older investors will live much longer than they currently expect. During this time, the investor has a stream of liabilities, or expenses, which will vary with inflation. By not having an asset that insures against inflation over the immediate investment horizon (which is roughly to the maturity of the Sydney Airport 2030 ILB) an investor increases investment risk, relative to inflation. In other words, most investors have an investment risk out to 2030 which is as large, or larger than, the duration risk of the 2030 bond. By taking on the duration risk one does two things.
- first, one reduces total portfolio risk incurred through the purchase of equities, as the fixed income instrument has a low correlation to equities, and
- second, one reduces the inflation risk that one faces. Hence, although in isolation the bond looks like having a lot of risk, the ILB effectively reduces total risk to the investment portfolio, when one considers inflation risk and the volatility of equities within the portfolio.
Hence, the answer to this question is answered by considering ILBs within the context of the broad risks facing investors, rather than focussing on the security itself, or in isolation from the context facing investors.
Reversion to “normal” rates
Many investors ask the question about what will happen when rates revert to “normal”. Typically, “normal” is meant to indicate that short term interest rates move back up to around 5%.
First, we would indicate that “normality” has very little to do with the current economic situation, or the one expected to exist for the next three years. This is because growth will take time to overcome spare capacity in the US economy, while Europe sinks deeper into debates and recession. Chinese growth will struggle in a low growth environment, and this leaves the RBA having to leave rates low for a long time.
Second, if rates rise, we expect that there will be a compression of spread between the Sydney Airport 2030 ILB and the Commonwealth Government (CGL) ILB, as explained below, where a recent rise in CGL yields has demonstrated this compression procedure quite well.
Figure 1
As the above chart indicates, when rates rise several things will happen at once:
- the CGL yield rises less than the nominal bond, so if the nominal bond rises 100 bps, one might expect a rise in the ILB of roughly 33 bps, although that relationship varies
- the CGL yield will rise faster than the corporate bond yield, as market participants use the liquidity in the CGL to express interest rate views. This was demonstrated recently with the CGL as shown above by the light blue line, and
- the interest rate spread, between the Sydney Airport 2030 ILB and the CGL 2030, should compress, as we see above as shown by the dark blue line
In other words, a “normalisation” of rates will mean that the interest rate spread, between the Sydney Airport 2030 ILB and the CGL 2030 will contract, and that the rise in the Sydney Airport 2030 yield should be somewhat limited.
Credit Risk
FIIG has followed the credit developments of Sydney Airport for many years and has highlighted the strengths and weaknesses of the credit in detailed research reports, along with other credit securities that we offer to our clients. One of the key questions raised in that research is the question about a second airport in Sydney. Here is an edited response to that question,
Whilst a ‘second Sydney Airport’ is often raised as a risk for Sydney Airport, we believe the risk to be limited. The current Sydney Airport masterplan shows the existing airport is able to meet forecast passenger number requirements through to 2029 (the masterplan was for the 20 year period 2009-2029) with passenger forecasts more than doubling from the current 35 million to almost 79 million. This is achieved through improved technologies and larger aircraft and without changes to current regulatory constraints such as curfews and noise caps. Further, the owners of Sydney Airport hold first right of refusal over the development of any second major airport within 100km’s for the first 30 years of their lease (2028) (Sydney Airport Finance, FIIG Research, 25 March 2013).
Historical relative value
Australian bonds have rallied a long way; more than one would have expected. However CGLs are low in yield for a very important reason; other developed world economies are experiencing difficulties in restarting “normal” levels of growth. Reasons for these difficulties centre on asset price deflation, and deleveraging, in these economies. While some economies, like the US, are dealing with these issues faster than others, like Europe, the elimination of asset price deflation will occur when there is less financial leverage in each of the respective systems.
Figure 2
While Figure 2 (above) shows the broad sweep of Australian bonds since around 1989, Figure 3 (below) shows the more recent trading history. Initially, rates fell in Australia due to the inflation fighting credibility of the RBA. More recently, especially after 2009, rates have fallen in response to the deleveraging that is occurring in most developed economies. We expect that, unlike investment banks who are paid to sell risky assets, this procedure will take time to eventuate. While the US recession was bigger and deeper than most thought, the European recession is now shaping up much the same. As Janet Yellen, Vice-Chair of the FOMC indicated some time ago,
... recent revisions of economic data by the Commerce Department’s Bureau of Economic Analysis indicate that the recession was deeper, and the recovery weaker, than previously estimated. Since the beginning of the recovery in the third quarter of 2009 through the second quarter of this year, the most recent quarter for which an estimate is available, real gross domestic product (GDP) expanded at an average annual rate of about 2-1/2 percent, a slower pace than during the first two years of most U.S. recoveries in the past half-century [emphasis added] (p.2, The Outlook for the U.S. Economy and Economic Policy, Remarks by, Janet L. Yellen, Vice Chair, Board of Governors of the Federal Reserve System, at the 2011 Annual Meeting of the Financial Management Association International, Denver, Colorado, October 21, 2011).
Figure 3
Notice in Figure 3 (above) how as rates have fallen recently, the higher yielding bonds like the QTC 2030 ILB have fallen in yield, relative to the CGL ILB. However, the Sydney Airport 2030 ILB yield has not fallen as much as bonds like the QTC. This lag in the yield decline in the Sydney Airport 2030 ILB is making these bonds look excellent relative value, given that the credit position of Sydney Airport is unchanged.
This is further illustrated below in Figure 4, which plots the difference between the yield of Sydney Airport 2030 ILB and the yield of the CGL ILB. The wider the differential, the cheaper the Sydney Airport 2030 ILB (all else being equal).
Figure 4
Reasons why the credit ILBs remain cheap
Several reasons exist for the lag in the rally of the credit ILBs, and they are as follows:
- before the global financial crisis (GFC), the credit linker index was much longer than the CGL, as the Commonwealth was not issuing ILBs, so institutional mangers switched mandates towards the credit ILBs, so as to match longer dated liabilities,
- most of the issues were highly rated, as a result of insurers or “wrappers” insuring payments to investors, even though most issuers were already investment grade, or rated above BBB-,
- after the GFC, the Commonwealth began issuing ILBs again, which led some institutions to change the mandate back to government only, as the government market satisfied the need for longer dated liability-matching assets,
- after the GFC, the wrappers were downgraded, which forced some institutional investors to sell, not because of impending default, but because of mandate restrictions, mainly imposed on the manager by investment consultants or others, and
- investment consultants continue to restrict many institutional managers from purchasing credit ILBs, due to a strict apportioning of all risk toward non-bond asset classes, although this may be beginning to change.
These developments combined to lead some institutional managers to sell their credit ILBs, not because they wanted to sell, or that they feared default, but mainly because they were forced to, by various procedural rigidities; rigidities that are now beginning to be shaken free. As institutions sold, FIIG clients have bought, along with other savvy investors, and now the holdings of credit ILBs are much more diversified than they were before the GFC; where “hold to maturity” investors are the order of the day, as opposed to highly constrained institutional managers with large concentrated holdings.
Why the Sydney Airport 2030 ILB should approach “par”, or 3.12% real
Typically, when a bond trades in the secondary market at the rate at which it has pays coupon, it is referred to as trading at “par”. While a nominal fixed rate bond will approach 100, in price, as it approaches the coupon rate, an ILB approaches the adjusted capital value, which increases over time with inflation. As the above section indicates, various institutional rigidities have forced the selling of cheap assets, and the following factors tend to support the existence of a gradual rally in Sydney Airport 2030 ILB, as just one example of broader rally in the credit ILB asset class:
- restrictions on institutional mandates are gradually lifting, leading to a gradual widening of institutional interest in credit ILBs,
- institutional managers are beginning to market “real return” funds, which target returns above inflation. While not constrained to ILBs, such funds will eventually purchase credit ILBs,
- rates are expected to stay lower for longer, meaning that credit ILBs will produce what investors need; generous “real” returns, while term deposit spreads gradually moderate,
- rates near 4% real remain very attractive, as 4.5-5.5% real is the target rate of return for sovereign wealth funds, who target “long term stable cash flows with an inflation linkage” (Future Fund Briefing, February, 2013),
- investors are beginning to think more carefully about inflation as a primary risk in portfolio construction, and credit ILBs are the natural choice for investors who recognize the significance of inflation risk,
- credit ILBs represent conservative investments with typically solid investment grade ratings, and FIIG will continue to monitor these credits carefully, so as to keep our investor base fully informed,
- supply of credit ILBs will remain low, as issuers see them as being expensive to issue, relative to nominal bonds, and
- gradually increasing levels of investor education will support ongoing demand for credit ILBs, in an age of low return and continued equity market volatility.
All these points support the ongoing demand for credit ILBs. By way of contrast, there may be risks to this outlook as follows:
- equity markets may decline in value, leading to a possible widening of the credit spread for credit ILBs, although this should be limited, as institutional holders of credit ILBs are less prominent at this time, when compared to before the GFC,
- credit profiles of the issuers could deteriorate, although we see these risks as limited,
- rates could be “normalised” sooner than we think, although we expect that the vast majority of the rise in rates will be reflected in the CGL ILB, as opposed to the credit ILB, and
- interest in ILBs could suddenly collapse, although this is unlikely as inflation remains the central risk for all forms of saving.
Weighing up the possible costs of investing in credit ILBs, against the possible benefits, we think that the benefits definitely outweigh the costs. While no investment is without risks, these securities more than compensate for the risks involved.
Conclusion
If the direction of credit ILBs is set for lower yields, as we estimate, then since inflation remains a key risk to your retirement savings plan, the need to obtain exposure to ILBs, as soon as possible, should become evident. Also, the opportunity to insure against inflation at a high real yield just does not exist elsewhere; one has to incur much more volatility to inflation when other asset classes, like equities, are considered for inclusion in the portfolio. Relentless investor demand for ILBs is what we have seen, what we are seeing now, and what we expect in the future, as the cheap inflation hedges become less cheap. Specifically, we think that yields on credit ILBs are set to go significantly lower in the next twelve months; for the Sydney Airport 2030 ILB to approach the par level of 3.12%. At this time, the need for above inflation returns are greater than they have been in many years, as the cash rate has provided great, above inflation, returns for many years in Australia.
Yet, all that is about to change; the good times have ended.
Investors need to adapt the way they approach investing, in order to “survive”, from an investment perspective. Like other developed markets, the low nominal rate environment can be expected to lead a depression of real yields, and investors need to get in front of these changes, and exploit any relative value opportunity in the fixed income market. In many ways, we believe that Sydney Airport 2030 ILBs represent such an opportunity.