Head of MIPS, Kieran Quaine continues to deliver outstanding results. Here we feature excerpts from the year end report, specifically from the low risk bank bond program, primarily for institutional clients. Kieran shares his key investment strategies
Summary
In combination, the Portfolio Management Team (PMT) believe credit margin weakness in the banking sector and the increased forward rate sets, will deliver a higher yield opportunity to those investing in this sector. We favour investing on any weakness. The tables below provide an overview of the Bank Bond Floating Rate Notes (FRN) Investment Program.
Total Gross Returns on Bank Bond (FRN) Investment Program
Source: FIIG Securities
Table 1
Exposure Category for Bank Bond Program
Source: FIIG Securities
Table 2
Our strategy recommendation is simplistic and based on our prior key observations. We see the widening in credit margins as an opportunity for investors.
Recent macro prudential controls on bank lending will support credit margins, capping the extent and time, perceived short term weakness can continue. As discussed, weakness in credit margins for term FRN product has not been significant. We continue to roll up the yield curve, positioning portfolios to maintain the current weighted average or longer term exposure. This takes advantage of ‘riding’ the steep shape of the credit curve.
The dual advantage delivered is higher credit margins and base interest rate sets. Higher base interest rates is not a beneficial investment strategy but an asset allocation advantage, where the investor’s choice to opt for floating rate over fixed rate assets avoids potential under performance should interest rates rise.
Bank Bond (FRN) Investment Program (BBIP) outlook
The widening of bank bill rates above official cash had a brief respite during the quarter, contracting from around 60 to 40 basis points, before resuming a widening path. See Chart 1 below. This section should be read in conjunction with the explanations delivered in the prior quarterly report, as the same observations hold true.
Three month bank bill interest rates and the official cash rate
Source: MIPS Quarterly Report – June 2018, FIIG Securities, page 4
Chart 1
Credit margin deterioration is attributable to demand not matching supply at the old price point - the old credit margin. The margin widens until the supply is absorbed. Supply in this case is the bank bills and bank bonds issued, and demand is the capital invested in those products. In the current environment, the longer dated credit margins for banks have only deteriorated slightly, and certainly far less than shorter dated credit margins.
So why is that the case, especially where tightening regulations on the banks is forcing them to hold more capital and lend more prudently? An environment that also very recently delivered share price gains.
Normally the answer would be that investors perceive bank credit as a riskier proposition than they did previously and need more margin to entice them to invest in the sector. But since longer dated credit margins have not sold off aggressively, the answer comes down to liquidity.
There is less confidence in the liquidity of short dated bank issued bills than previously and/or investors are repricing margin expectations given those offered for short dated term deposits issued by the same credit. The competition for capital is getting somewhat crowded.
What does the future then hold?
Any widening of short dated credit margins will eventually, if not immediately, have widening implications for longer dated products. If bank credit margins widen, then so too will corporate credit margins. For this reason the PMT is cautious when selecting longer dated corporate credits for the portfolio. Future rate set expectations, or ‘forward BBSW’ rates, will be higher if short term debt margins remain wide.
The higher BBSW rate sets delivered in this environment are of course more attractive than the previous rate sets. This is good for FRN investors, but only if there is no subsequent deterioration in the floating rate note credit margin that would see the accrual uplift offset by a capital loss.
The QoQ interest rate swap yield curve change showed a marginal fall. In isolation it depicts the interest rate swap curve strength. In reality it has been weak because the Federal government curve has rallied further.
In summary, short term bank rates have gone up while official cash, the Federal rate, has remained stable. Also long term bank bill rates as reflected by the interest rate swap curve have fallen very marginally even though the long term federal government yield curve has rallied marginally further.
Tables 3 and 4 below provide further details on the Bank Bond (FRN) Investment Program outlook.
Bank Bond Investment Program Analytics
Source: FIIG Securities
Table 3
Specific FRN asset example changes for constituents of Bank Bond programs
Source: FIIG Securities
Table 4
Credit margins are slightly wider, but the interest rate swap curve has also rallied slightly. Total book value entry yields have fallen slightly. Note the exception is the BB2 program where constituents have changed markedly. Given constituent changes, any QoQ comparison is best undertaken alongside discussion with the MIPS PMT.
Selected asset examples showcase a widening in credit margins. Note that credit margin widening has effectively been linear, with lower rated, subordinate assets of longer maturities underperforming higher rated, senior assets of shorter maturities.
To learn more about the MIPs Bank Bond program, please call Marcus Blake on (02) 9697 8756 or (0436) 345 251.
For a full explanation read the current report here.
For the previous report dated 31 March 2018, please click here.