Bond market wobbles no cause for panic

Glenn Freeman  |   21/03/2017 Text size  Decrease  Increase   |  
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Glenn Freeman: I'm Glenn Freeman for Morningstar and I'm joined today by our senior credit analyst, John Likos.

John, thanks for joining us.

John Likos: Thanks for having me.

Freeman: Now, John, just firstly, at the start of this month we've seen the US Federal Reserve increase interest rates again. What does this mean for Australian fixed income investors?

Likos: Yeah. Look, I think, the Federal Reserve, when they recently upped their rates, they probably actually maybe still came under market expectations in terms of the potential level of increases during the course of the year. But nevertheless, what we did see was still a general widening in bond yields, particularly, the longer-term-dated notes and that was reflected in Australian bond yields as well. So, we saw our 10-year rate increase as well towards 3 per cent.

Now, what that effectively means is we are now going to require potentially more return when companies or governments got an issue at that longer tenure. So, there's been a little bit of a tremor in Australia. Look, it hasn't been overly significant.

We've seen some actions, potentially through the banks, et cetera, in raising some of their book prices on some of their investor loans, possibly just getting ahead of potential increases in funding costs which have been prompted by the reassessment of these longer-term yields.

Freeman: And what are the implications for some of the other global bond markets?

Likos: Yeah, we've seen sovereign yields come off their lows in the last three to six months effectively throughout Europe and the US possibly of a little bit of longer timeframe and even Australia.

So, we've come off from 1.8 per cent roughly in the 10-year to about 3 per cent. So, investors that have exposure to fixed coupon fixed income securities will experience the greatest potential capital losses of that – if they don't sell, there'll be paper losses.

But the fixed rate coupons will lose the most in an increasing interest rate environment. However, if we're talking floating rate notes, then they are buffered because they remove that interest rate risk as benchmark rates go up.

So, look, generally speaking, there's definitely been a bit of a wobble in global bond markets as the markets begin to reprice the curve upwards as opposed to what we've had for such a long time which has been a tailwind for a 20-year bull run in bond markets.

All of a sudden, we are getting a little bit of a turbulence, but that's by no means any reason to be afraid or think you've got to jump ship from the fixed income or credit asset class because as always it provides a critical function in any portfolio.

Freeman: Now, last time we spoke, we discussed the NAB subordinated notes and since then we've also put out some commentary on the ANZ and Challenger hybrids. Can you just talk us through what's happening there?

Likos: Yeah, sure. As you said, we wrote up a note on the NAB subordinated notes too and they actually list today. Probably as we speak they are coming on market. We think they will generate significant support in the marketplace. There are Tier 2 securities, so they are less risky than your AT1 hybrid securities and we're very – our recommendation was to subscribe. We'll see where the actually security price is and then we'll issue our initiation of coverage note on that.

We've also written up a note, as you say, on the Challenger hybrid securities. Now, they are not due to list for another few weeks; however, we recommended investors subscribe on the basis that they are high-risk investors.

So, we want to make that very clear. This is a high-risk investment. If your first hurdle isn't met on the basis of what is your risk-return profile, if you consider yourself medium-risk or below, then you can just put that aside.

But if you consider yourself high-risk or above, we think it offers compelling value at current prices. Now, the book build on that's closed; however, once it lists, it will be worth monitoring.

The other security, as you mentioned, that we've written something up about recently was the ANZPC. This is kind of an older security. It's a Basel II-type security. It was issued under the previous regime as opposed to the Basel III.

It doesn't have all the triggers that the new hybrids have. It doesn't have the capital trigger, for example, but it does have the non-viability trigger. Look, we've been a bit brave on this one. We've made the call that we believe ANZ might not actually call the security at its first call date; however, we think it makes sense for them not to do so.

So, we are by no means worried. If anything, we'd almost prefer to happen because it will be the result of a decision made on the basis of economic merit. If it's not called in September this year, which is the first of September, it will likely be called within the next two years.

And what will happen effectively is there will be a pickup in yield to eventual call date if they don't call at the first call date. So, our recommendation of hold remains under either circumstance. If they do decide to come back and replace with a new security, then we will examine the merits of that new security at that time.

Freeman: And John, what about some of the so-called bond proxies, the listed real estate, infrastructure and the utilities sectors?

Likos: Yeah, look, a lot of those securities have always been purchased on the basis of their dividend yield, for example. Now, all of a sudden, we're seeing benchmark rates increase. So, the dividend on those securities, the gap isn't as big anymore as what it was.
So, as the benchmark rates increase, well, all of a sudden, the premium decreases and people are starting to think to themselves perhaps the new premium isn't enough. And so, we're seeing a significant outflow from those securities, those bond proxies, as you'd say. So, again, in saying that it's been somewhat volatile. We've seen some of these REIT prices be particularly turbulent in the last three to six months. But again, that's probably a question best left for our Morningstar equity analysts.

Freeman: Now, just lastly, we've just over a week in March. What's your outlook for the month overall?

Likos: Yeah, look, I think, it's a relatively quiet week in terms of news flow this week. I don't think we'll see too much. I mean, the NAB note will get some maybe airplay in terms of listing today and we'll see how that goes. It will be a pretty quiet month, but we provide a summary of every month in our credit monthly. Investors can access that ordinarily in the first few days of every month and that's a good little snapshot via charts and a little bit of text in terms of what's happened during the month.

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

Likos: Thank you.

Freeman: I'm Glenn Freeman for Morningstar. Thanks for watching.

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