Equity and hybrid investors react as bond prices tumble

Glenn Freeman  |  24/11/2016Text size  Decrease  Increase  |  

Glenn Freeman: I'm Glenn Freeman from Morningstar and I am joined today by our senior credit analyst, John Likos.

John thanks for joining us.

John Likos: It's good to be here.

Freeman: Just firstly John we've obviously seen some quite significant market changes since the surprise election result in the US. Can you just talk us through that briefly?

Likos: Yeah, absolutely. I suppose that the key distinction between the Trump victory and what could have been the Clinton victory, is Trump's embracing a very expansionary fiscal policy in his initiatives or at least what he is proposing. Whereas Hillary Clinton would have effectively been pretty much status quo, much of the same.

So, the market is, aside from being taken aback by the result, is now repricing its expectations on future policy direction.

And in doing so is now expecting greater fiscal expansion and less emphasis on the monetary policy as has been the case for many years.

Freeman: And John, what's the reason for the shift in the correlations that we've seen between fixed income and equities?

Likos: Absolutely. So, what's now happened is as we've seen the sovereign, the bond markets have repriced significantly.

So, bond prices have tumbled at least among sovereign bonds and we've seen global yields all over the world increase sharply, and in the meantime equity has risen.

So, what we are now seeing is a return to that negative correlation between, well in this case treasury bonds and equities. So, bond prices are falling and stock prices are going up. As a result of the increasing expectation of fiscal expansion that Donald Trump wants to embark on.

And what this means and why this is happening is basically because inflation is a greater risk when you have fiscal expansion, and inflation is the bond market's worst enemy.

So, that is scaring bond investors whereas equity investors love the sound of spending money on infrastructure or what have you. And are expecting greater growth, economic growth and are therefore buying up shares and selling the sovereign bonds.

Freeman: And John, within the Australian context, can you also explain for us the distinction we see between hybrid products and traditional fixed income.

Likos: Absolutely. We discuss this at length in our hybrid handbook, which we recently released. The clear distinction is the traditional fixed income product is far safer, less volatile product than the hybrid.

In the case of a bankruptcy, your traditional fixed income investor will probably get back about $0.40, $0.50 in a $1.

Whereas a hybrid investor will probably get $0.05 in a $1 at best. Just to put that in context in terms of recovery value and how they sit on the risk scale. In terms of their features, and their structure, and their characteristics, I suppose the biggest difference is hybrids in Australia tend to be floating rate notes.

So, they have floating rate coupons, they have margin on top of BBSW rate, the benchmark rate. Whereas many traditional fixed income securities have a fixed coupon.

So, no matter what happens to benchmark rates that return amount remains the same. In many ways a hybrid investor is protected against interest rate risk or increasing interest rates, because the benchmark rate will go up.

That’s one clear distinction in terms of pricing and that’s again why we are seeing hybrids holding up really well. Whereas your fixed coupon bonds again particularly at the sovereign level are getting hit very hard.

Freeman: And just finally, now that we are almost at the end of 2016. What do you see on the horizon as we move into the first quarter of next year?

Likos: I think volatility is going to continue to be a theme. With President-elect Trump, he has a lot of ideas, but it's still going to be hard to actually execute these because there is a lot of hurdles he has to go through within the U.S. government.

So, he still needs approval by his own House effectively and that’s no guarantee that all the Republicans are going to vote in favor of a lot of what he is proposing and suggesting.

We're going to have some hurdles. We're going to have some roadblocks and the markets will continue to reprice expectations on the back of that. Australia is going to continue to be led by what's happening in the US.

However, if we look more domestically than, look I still think we have a pretty strong economy. I think unemployment is something we need to keep an eye on as a key risk. But I do expect the markets to continue to trend upwards over time despite this volatility in the meantime.

Freeman: John, thanks very much for your time today.

Likos: Thank you.

Freeman: I'm Glenn Freeman from Morningstar and thanks for watching.

Video Archive...

Earnings season FY17 mixed bag so far
18/08/2017  Aside from a few high-profile earnings guidance misses, large-cap stocks are doing okay as FY17 reporting season passes halfway, says AMP chief economist Shane Oliver.
Rio Tinto posts mixed result for 1H17
10/08/2017  An interim result of US$3.9 billion in net profits after tax for one of the world's largest mining companies was positive but slightly weaker than expected, even alongside a record dividend, explains Morningstar's Mat Hodge.
Kerr Neilson on why global investment exposure is key
07/08/2017  There are two types of investors, regardless of market noise, imputation credits, diversification approaches and market indices, says the managing director of Platinum Asset Management.
Finding fixed income opportunities in new paradigm
02/08/2017  Slowing economic growth in the US and parts of Europe emphasises the need to carefully select credit opportunities, says Vincent Reinhart, chief economist, Standish Mellon Asset Management.
Exclusive: An interview with Westpac CEO, Brian Hartzer - Part 3
20/07/2017  Insights on Australia's housing market, China's effect on domestic banks, and cyber-security readiness, in the final instalment of Brian Hartzer's interview with Morningstar's David Ellis.
Telstra won't be blown away by headwinds
17/07/2017  While it faces what Morningstar equity analyst Brian Han describes as a whirlwind of negatives, he suggests investors shouldn’t hang up on Telstra.
Exclusive: An interview with Westpac CEO, Brian Hartzer - Part 2
13/07/2017  Westpac CEO Brian Hartzer joins Morningstar banking analyst David Ellis to discuss digital disruption, regulatory change and Australian banks' social license.
The home-truths of investing
12/07/2017  Look for companies that sit outside the cycle; heed the lessons of history; and remember the power of compounding, says Bennelong's Neale Goldston-Morris.
Exclusive: An interview with Westpac CEO, Brian Hartzer - Part 1
06/07/2017  Brian Hartzer, CEO, Westpac joins Morningstar senior analyst David Ellis to discuss his role leading Australia's oldest bank, how Westpac can continue to grow value, and its commitment to sustainability.
Self-managed super is not Do-it-yourself
03/07/2017  There are a few common pitfalls in running a self-managed super fund that mean trustees shouldn't go it alone entirely, says BT Financial Group's head of financial literacy, Bryan Ashenden.
Investing to protect on the downside
30/06/2017  There are investment strategies you can adopt to mitigate volatility-linked fear and uncertainty in markets, explains Roy Maslen, chief investment officer – Australian equities, AllianceBernstein.
Don’t overdo benchmark consideration
28/06/2017  Being benchmark agnostic is the most effective approach to fixed income investing, according to Anujeet Sareen, portfolio manager, Brandywine Global.
Factor-based investing using ETFs
26/06/2017  Investors should consider style-exposures--such as value, defensive or yield-- they would like in their portfolios, explains Jonathan Shead, head of portfolio strategists – Asia Pacific, State Street Global Advisors
Volatility plays to active manager strengths
--  The climate of political volatility in the US holds important implications for investors and the funds they invest in, particularly around Donald Trump's ability to pass legislation through Congress, says Pimco's Libby Cantrill.
Is the FTSE 100 Facing Another Market Crash?
16/06/2017  Ten years on from the pre-crisis FTSE 100 high, Morningstar UK's Emma Wall examines how UK stocks have fared
How to guard against retirement threats
16/06/2017  As retirement approaches, even the best-laid plans can go awry, as Tim Steffen tells Christine Benz, Morningstar US.
PIMCO Global Credit Fund
07/06/2017  The PIMCO Global Credit strategy receives a Morningstar Analyst Rating of Silver due to its sizeable and highly capable credit research team.
PIMCO Income Fund
07/06/2017  Morningstar's Tim Wong looks at the strengths and competitive advantages of this Silver-rated strategy.
3 pockets of opportunity in fixed income
07/06/2017  The head of PIMCO Australia portfolio management explains his views on active management in fixed income and outlines where he sees most value in this space.
Trump administration biggest macro threat for investors
05/06/2017  Even as European political volatility subsides, the US Government remains a considerable threat to financial markets, says Colleen Barbeau, director of equity portfolio management, Franklin Templeton.