Ask the Expert: John Likos on global growth, franking and hybrids

-- | 05/04/2019

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Lex Hall: Hi, I'm Lex Hall, and welcome to the Morningstar series, "Ask the Expert." Today I'm joined by John Likos who is director of equity and credit research at Morningstar. We are going to talk about bonds, we are going to talk about hybrids, and we are, of course, going to talk about the issue that won't go away in the lead-up to the election, franking credits.

John, thanks for your time.

John Likos: Good to be here, Lex.

Hall: Now, bonds have very much been in the news of late because the rate on 10-year treasuries has fallen below the three-month treasury bill yield. This is the first such inversion since 2007. And people sort of see this traditionally as a bit of harbinger or a sign of a coming recession. Do you think we should be that anxious? What are your thoughts on that?

Likos: Yeah. Look, it's a good question. It has been the focus of a lot of media attention of recent times. Rather than get caught up in the detail I think it's important to look at the bigger picture and understand what really is at work that's driving these dynamics; what is actually driving the 10-year down to the point that it's now below the three-month and reflecting that expectation of a coming recession? Now, we should also mention it hasn't always predicted recessions, but it has in certain instances as well.

From our perspective, what's happening globally is a repricing of growth expectations and we are seeing in the US, we are seeing in Australia, the market’s revising its expectations of interest rates — and inflation as well. And what that's doing effectively is, it's increasing demand of duration, longer-dated fixed-income notes; and we've seen a rapid fall in the yields of, let's say, the 10-year government bonds of the US and Australia — almost at long-term lows, all-time lows, particularly in Australia's case.

So, what we are seeing is the market telling us that we think there is a slowing growth profile coming. So, investors naturally need to ask themselves: “where is my portfolio positioned in the event that that does happen?”

Hall: Okay. Now, you are — I don't want to embarrass you here — but you are one of Australia's preeminent commentators on hybrid securities. Hybrids share, in a nutshell, characteristics of bonds and shares. What are you seeing for 2019 in hybrid securities?

Likos: Hybrids have been particularly resilient in the last three, six months. We had a period in February where there was a bit of profit-taking. It seems to coincide at the time of some new issuance. So, we've had the NAB PFs (ASX: NABPF), we've had the Macquarie PDs (ASX: MQGPD), we have had some new supply come to market this year. Now, simultaneously, there was a rally towards the end of last year. It all culminated in a little bit of a sell-off, like I said, in February, earlier this year. But since then, we've seen a recovery. We've seen the new hybrids, the NAB PF, the MQG PDs, list at a premium to their listing price and maintain that strength.

Now, we continue to believe that hybrids have a position in a well-diversified portfolio. But again, we highlight, these are medium-risk products and exposures, not low-risk and they do not substitute for fixed income or for term deposits. But there is some uncertainty coming and we've discussed this in several publications, that particularly being regulatory risk that comes with a Labor government victory. The franking discussion that has dominated the hybrid landscape for many months now remains unclear.

Hall: You sort of anticipated my question in that sense. I know you are a bit of betting man. Labor’s short-price favorite to win the election, which has been slated for around 11 May. One of Labor's key election policies is, of course, to axe cash refunds for franking credits and there's been a lot of debate around it. What impact do you think specifically this will have, if any, on hybrids?

Likos: Yeah. Well, I think last time I looked, Labor was about ($1.20) and the Liberal Party were about ($5.50). So, there's a clear expectation that Labor will win this election. The next question we have to ask is, what happens in the Senate? And there's some uncertainty there. There's a lot of uncertainty. But basically, that is a major hurdle to get this legislation through. However, that is not a slam-dunk in our view. But let's just say it does happen and Labor does get it through the Senate and the House of Reps and it becomes law.

A good example is, let's say, a NAB PF: at the time that it was issued, it was yielding to its first call date 6 per cent. If you can take advantage of the franking credits to their full extent, you’ll benefit from that yield. You get 6 per cent effectively if you hold it to call —and that's assuming the BBSW (bank-bill swap rate) stays at 2 per cent, and that's just an assumption anyway, which, albeit unlikely, but just for the sake of this example. However, if you cannot take advantage of those franking credits and get the cash rebates, to any extent, then your return moves from 6 per cent to 4.20 per cent. That changes everything. All of a sudden, that 4.2 per cent return you are getting becomes a lot closer to other products on the capital structure which have seniority. And therefore, you ask the question, “why would I hold a more subordinated product if it's yielding the same as something that's higher up on the capital structure?”

So, again, we see a lot of uncertainty from clients. You really need to understand: “how am I impacted by the franking credit proposal?” Am I impacted to the full extent so that my return goes from 6 per cent to 4.20 per cent in this example; to some extent, let's say, 50 per cent, where it drops in the middle, or to no extent where it's 6 per cent. Because if you are at the lower end where you are now returning — or you are receiving — 4.20 per cent — then all of a sudden, I dare say, hybrids products are not for you.

Hall: Okay. Very valuable insights. Thanks very much, John.

Likos: Thank you.

Hall: I'm Lex Hall. Thanks for watching.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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