Tuesday 04 March 2014 by FIIG Research Legacy

From the Trading Desk (04/03/14)

Yield direction and volatility

Yields moved significantly lower over the week after lower than expected Capital Expenditure (capex) figures were released for Australia, and unrest in the Ukraine continued. Capex was down 5.2% in the December quarter, which was the biggest drop in over two years and has been attributed to the fall in mining related spending. Of further concern was the projection of corporate spending in 2014-2015 ($124.9bn), which indicated a further 23.5% decrease from the 2013-2014 expectations ($167.1bn).

Meanwhile the tension in the Ukraine heightened as gunmen occupied parliament and the government building in Crimea, while lawmakers in Russia voted in favour of sending military to the area.  The geopolitical unrest sent yields lower with the 5 year and 10 year benchmark swap rates moving 8-10 basis points (bps) lower to close the week at 3.62% and 4.41% respectively. Similarly there was a downward spiral on the Commonwealth government bond yields as the 5 and 10 year bond yields moved 14-15bps to end the week at 3.30% and 4.02% respectively.

As universally expected, the Reserve Bank of Australia (RBA) left the cash rate unchanged at 2.50% yesterday. The accompanying statement by Glenn Stevens indicated a combination of positive and negative economic signals, which would imply interest rates should remain stable at current levels over the short term.

Time to shift to a more balanced fixed income portfolio

Regular readers of this column will know that I have been suggesting for some time now that medium term fixed coupon bonds offer the best relative value in the market, due to the interest rate climate of low nominal rates and a steep yield curve. This has served well as swap rates five years and out have fallen by 20-25bps over the past six months and holders of fixed coupon bonds have enjoyed the bonus of the natural progression down the yield curve. With five year swap rates nearing 3.5% and risks being fairly even between the RBA easing vs tightening interest rates, the value in this proposition is weakening and it may be prudent to shift portfolio allocation to a more balanced composition of fixed, floating, and inflation-linked coupons.

New G8 FRN now available in the secondary market

The new G8 Education floating rate note began trading in the secondary market on Monday, at a starting offer level of BBSW+3.32% (for a capital price of $101.00). For those who missed the opportunity to participate in the primary market (or were scaled back and did not receive a full allocation) these levels still look attractive on a relative value basis (see Figure 1 below).

Figure 1

Qantas short term risk flips to the downside

Qantas reported its much anticipated half yearly results to the market on Thursday, confirming a $252m loss and announcing plans to cut 5000 jobs over the next three years. In the lead up to the news, the margin on the April 2020 bond traded 16-17 bps tighter, but then widened 14 bps after Tony Abbott told Parliament it would be unfair to make the company a special case and had cooled on the prospect of a debt guarantee.

With the bad news regarding earnings in the market and no immediate positive response from the Commonwealth government, now may be a good time for investors who bought Qantas bonds above a 7% yield to take profit. Without a solution agreed in parliament, it seems less likely that the yield on this bond will continue to contract (traded as low as 6.50% and currently bid at 6.80%) and more likely that it will drift back upward toward the levels seen just after the rating downgrades (7.10% to 7.50%).

To be clear, we do not foresee a fundamental risk in Qantas’ ability to pay full coupons and principal at maturity on this bond, and investors happy to continue holding at levels where they originally purchased should continue to do so; but for those who jumped at the opportunity post-downgrade for a short term gain, those profits can be expected to deteriorate over the short term.

New DirectBond

For the third week in a row, FIIG added another USD bond to the DirectBonds list, this time the USD FIX-FRN line issued by QBE Capital Funding II L.P. The bond has an initial call date in June 2017 and no final legal maturity. It is available to wholesale clients only and, unique to this line, it cannot be purchased by any account which is a trust or SMSF. It can be purchased in minimum parcel sizes of USD100,000 and pays a fixed semi-annual coupon of 6.797% until 2017. If not called in 2017, the bond switches to a floating rate note (FRN) paying a quarterly margin of +262.5 above the 3-month US Libor rate. QBE is a general and reinsurer with significant operations in Australia, USA and Europe.

Other credit margins and trading activity

Trading among inflation linked bonds (ILBs) was more subdued last week with the majority of activity coming from the Sydney Airport 2020 and 2030 lines. A total $7m turnover was recorded across the two lines as steady supply continued. FIIG is currently well placed to fill bids in both lines. Current indicative offer yields are listed below:

  • Sydney Airport November 2020: 6.30%
  • Sydney Airport November 2030: 7.05%


Offer levels are indicative as at 04 March 2014 and subject to change based on demand and market movements.

Yields for floating rate notes are estimated as the sum of the swap rate to maturity / call and the trading margin.

Yields for capital indexed bonds and index annuity bonds are estimated as the real yield plus a 2.50% inflation assumption.