Archive for category: News & Insights

The listed income universe has not been immune to the recent market volatility that has engulfed global financial markets since the outbreak of the COVID-19 pandemic. Listed income securities covered by Lonsec have fallen 19% since early February 2020, giving investors very few places to hide. As the current market has made all too clear, hybrids are no guarantee of safety during a heavy market sell-off.

The price effect has been most severe for longer duration securities: those with more than five years to call have fallen around 25%, compared to 14% for those with less than two years to call.

Average price fall in Lonsec’s listed income universe

Source: Lonsec, Refinitiv

There have been three main drivers of this sharp fall in prices: the global rise in spreads, a lack of liquidity, and elevated risk of balance sheet stress for issuers.

The credit spreads of Listed Income securities have jumped since the pandemic was declared. As an example, looking at major bank AT1 securities with approximately five years to maturity, the average credit spread has widened from 275 bps to 783 bps.

This widening of credit spreads has not been confined to the Australian Listed Income market. The option-adjusted spreads of US Investment Grade and High Yield spreads, for instance, have jumped 334 bps and 652 bps respectively. The lift in credit spreads more broadly highlights the risk-off nature of the current market, with cash seen as the asset of choice and investors also concerned about rising default rates.

Hybrid trading margin versus Bank Bill Swap Rate

Source: Lonsec, Refinitiv

Further, the lack of liquidity in the secondary market has also exacerbated recent moves, with issue sizes for Listed Income securities ranging from as low as $268 million for AMP Capital Notes (AMPPA) to $3 billion for Commonwealth Bank (CBAPD).

While this may not appear small in comparison to the market capitalisation of some constituents in the ASX 200, the average trading volume is considerably less. For example, the historical weekly average trading volume for CBAPD is $10.3 million, and there are a number of smaller issues with associated poorer liquidity. This has increased to $17.3 million over the low level of turnover compared to the issue size of $3 billion, highlighting the impact of low liquidity on the market price movements of these securities over the short term. This is not unexpected, with investors in the current market seeking a much larger illiquidity premium to buy smaller hybrid issues.

The volatility inherent in the Listed Income universe at the moment is a reminder to investors of the equity-like characteristics of these instruments. When the market sells off, default risk and liquidity risk become more prevalent. It’s another cautionary tale during this period of market stress.

Banks face higher risk, but the probability of forced conversions remains low

Concerns about rising impairments for the big four banks has resulted in sharp share price declines in the sector, with share prices of the big four banks declining by around 36-48% since the start of the pandemic.

Given the perpetual nature of the AT1 securities and potential conversion triggers embedded in the structure of these issues, it is important to revisit the scenarios in which these Basel III compliant AT1 securities could convert into equity.

There are 3 possible scenarios in which conversion could occur:

1. A common equity trigger event: Common Equity Tier 1 (CET1) capital is comprised mainly of directly issued qualifying ordinary shares, retained earnings, and accumulated other comprehensive income, which is adjusted based on regulatory requirements. A breach and conversion of listed income securities into common equity occurs when the risk-weighted assets of the issuer are equal to or less than 5.125% of CET1 capital.
2. A non-viability event: This occurs when APRA declares the bank non-viable or considers that the bank would become non-viable without a public sector injection of capital.
3. Mandatory conversion: If the securities are not redeemed at the first call date, they are left on the market for two additional years

It’s important to note that in the event of a conversion, holders will receive approximately $100 worth of ordinary shares per security, unless the issuer’s underlying shares price falls below a certain pre-determined level at which point a capital loss is likely to be incurred upon conversion. The price level is usually set at 20% of the issue date VWAP for each security.

The below table outlines the current CET1 capital levels of the major banks and the capital buffer above the conversion condition. Thanks to APRA’s “unquestionably strong” CET1 requirement of 10.5%, Australian banks are well capitalised and would need to experience a significant rise in bad debts before a conversion trigger is enforced. As at 31 December 2019, the major banks had reported capital buffers in the range of $22-30 billion in excess of the minimum capital requirements.

Source: Company data. As at 31 December 2019

The volatility inherent in the listed income universe at the moment is a reminder to investors of the equity-like characteristics of these instruments. While the current volatility in security prices would be unsettling to investors, Lonsec believes that the risk of forced conversions into equity remains a very low probability event for the AT1 securities issued by the major banks. Lonsec continues to recommend a ‘hold-to-maturity’ approach for these securities. However, we also urge investors not to allocate to hybrid securities as part of their defensive bucket in their asset allocations.

Household consumption accounts for 56% of Australia’s GDP, making it the main engine of growth for the economy. When households cut back, the economy suffers, with flow-on effects to business and government in the form of lower sales and taxation revenue.

As consumers start making dramatic changes to their daily habits due to the coronavirus, what is the likely impact on discretionary spending and, by extension, GDP growth over the next quarter?

Based on the ABS national accounts data, rent and dwelling services is the largest component of consumer spending, representing 11.5% of GDP. This is followed by recreation and culture at 5.6%, food at 5.2%, and hospitality at 3.9%.

Australia’s consumption as a % of GDP

Source: ABS, Heuristic

Some of these components of household spending are more cyclical – that is, they’re more sensitive to changes in the economic environment. The table below, prepared by Heuristic, shows each sector’s growth during the 1990s recession when GDP dropped 1.4% over four quarters. For example, it shows that purchases of new cars declined 17.8%, while food rose 1.1%.

The second and third columns show the average quarterly growth of each component in ‘recession’ and ‘non-recession’ regimes. This gives us an idea of which sectors might be more ‘discretionary’. For example, communications may have grown 2.6% in the 90’s recession, but growth outside of recessions was 7.8% per quarter. The final two columns show the share of each component of overall consumption and GDP.

We estimate that 40% of consumption is ‘discretionary’, and therefore at risk in the current environment, at least for the next one or two quarters. Note that the ABS’s retail sales data is ‘discretionary’ and represents around 30% of consumption. We estimate discretionary spending is around 22% of GDP. Some of these sectors (such as hospitality) are experiencing declines of 50% or more, while others may experience declines of 10%. Other sectors are experiencing significant increases in the short term (such as food).

Given the nature of the coronavirus pandemic, transport services are unlikely to lift as it did in the previous recession, while recreation and culture will suffer more than in the last recession.

Spending on the discretionary sectors could decline by at least 17% over the quarter. This would force overall consumer spending down some 6–7%. Once we allow for an imported component of 20%, the potential near-term impact on GDP could be in the vicinity of 3%. Chinese retail sales data released earlier in the week revealed a 20.5% decline over January and February due to business and industry shutdowns.

Hopefully we start to see positive effects from fiscal stimulus, along with the rate cuts and other measures announced by the RBA, although this won’t be evident until the June quarter. The good news, if there is any, is that markets have likely already priced in a significant hit to GDP, meaning there shouldn’t be much of a reaction when the next GDP release comes along.

Consumption during recessionary and non-recessionary periods

Source: ABS, Heuristic

Diversification worked well in the last week of February 2020 as equity markets sold off in response to the rapidly escalating COVID-19 pandemic. Bond markets, notably the highest quality and safest bonds (government bonds and high-quality investment grade credit) rose in price, providing a cushioning impact to multi-asset portfolios. Bonds, as expected, provided good diversification benefits in what was a typical ‘flight to quality’ episode.

Roll forward to March and we are now seeing a very different market – one that is evolving rapidly. Most notably, bond yields have been rising, meaning prices have been falling. What’s going on? Are bond markets looking through the current bad news and pricing in an economic recovery? Usually yields rally in response to positive economic news, don’t they?  Unfortunately, this is not the case. Rising yields and falling equity markets are not a good combination for multi asset investors because it means correlations have risen.

10-year government bonds yields began rising rapidly in March

Source: Bloomberg, Lonsec

What we are seeing and hearing from our fund managers is that there are severe liquidity issues in bond markets. Our fixed income managers are reporting limited liquidity in what are usually the most liquid securities: government bonds. There are simply very few buyers of these assets and many sellers. Adding to the problem is the widening pipeline of bonds, with more supply on the way courtesy of government fiscal stimulus plans, which will be funded via new bond issuance. The impact of increased supply is, of course, to lower prices.

General deleveraging by investors is clearly taking place. Investors are selling any liquid assets they can – including bonds – to fund redemptions, margin calls, or simply to move into cash. Some of our fixed income managers have been taking profit, trimming their positions after building in additional duration to their portfolios in the second half of last year. Parts of the market are blaming hedge fund sellers (always the first and easiest to blame) and some are blaming social distancing, which is making it more difficult for bond traders to execute their trades working from home.

At the same time, we’ve seen companies drawing down their entire credit lines at banks in efforts to shore up their balance sheets and make it through the next few weeks, months, or quarters with little to no revenue coming in. Access to cash (or credit) is essential to keeping these businesses alive and through to the other side of this shutdown. Bills, interest payments and fixed costs still need to be serviced. Companies are hording cash, and those that held government bonds as part of their liquidity reserves are selling. The demand for liquidity has been great, and cash – or ‘cashflow’ – is certainly king in this environment.

In efforts to avoid a repeat of the global financial crisis, central banks are throwing everything they’ve got at this, flooding markets with liquidity to ensure credit markets continue to function and companies have access to funding. Stabilizing the government bond curve (off which all credit securities are priced) is a critical first step for a functioning credit market.

Here in Australia, the RBA announced a number of measures, including dropping the cash rate to 0.25%, providing strong forward guidance, introducing a term funding facility, and announcing its intention to buy government bonds across the curve to ensure the 3-year yield remains low at 0.25%. We expect a large buyer (with deep pockets) entering the market could go some way towards stabilizing bond yields. On the back of the RBA announcement, yields on the 3-year bond dropped from 0.62% to 0.35%. This is a good first step, however we will be monitoring markets closely to see if it is enough. Thankfully, we think the RBA still has more left in its arsenal if required.

Given the extraordinary movements we are all seeing in the market, we have decided to hold more frequent Investment Committee meetings and provide you with regular updates on our thoughts and discussions from a portfolio perspective.

Lonsec’s Investment Committees will now meet monthly, with additional meetings held as required, and we will send you a summary of our discussions to keep you up to date with the latest market and portfolio developments.

Our Investment Committees are comprised of our portfolio managers, heads of research, and external macro-economic experts. Our team utilises a combination of top-down and bottom-up analysis to establish our dynamic asset allocation positions. These will now be reviewed and updated at least monthly for our range of direct equity and manager portfolios (including our model portfolios and managed accounts).

Positioning leading into our March Investment Committee meetings

Leading into our most recent Investment Committee meetings in March, our overall active asset allocation positioning had a defensive bias. This included: a below target allocation to developed market equities; a positive tilt to emerging markets equities, real assets and alternatives; and a largely neutral allocation to fixed income assets.

The rationale for this positioning was based on our view that most asset classes were expensive – or at best fair value – while cyclical indicators were negative but improving, and the low interest rate environment was expected to continue. At the same time, the threat of ‘x factor’ events was ever-present, with geopolitical risks such as trade tensions between the US and China creating spikes in market volatility.

March Investment Committee discussion

One ‘x-factor’ few predicted three months ago was the COVID-19 virus (coronavirus), which has spread rapidly on a global scale. At the time of our March meeting, markets were heading into bear market territory (a drop of 20% or more) and market sentiment rapidly turned in anticipation of weak economic data in the coming quarters. Our in-house models showed valuations move towards fair value, but at the time of our meeting they had not yet reached ‘cheap’ territory.

Our base case was that we are likely to head into a mid-sized recession characterized by a market drop of around 30%. Committee members noted that, unlike the events of 2008, the banking system remained intact, but there was significant uncertainty about the duration of the virus, the possible flow-on effects throughout the economy, and the extent and efficacy of monetary and fiscal stimulus.

Asset allocation decision

The Committee decided to maintain the existing positioning with a view that markets had already pulled back and that there was still a high level of uncertainty in markets, which would result in high level of volatility.

We reviewed our positive tilt to emerging markets and decided to maintain the exposure. This was based on our view that it was one of the few asset classes that offered value leading into this environment, and that many emerging market economies had greater ability to stimulate via monetary or fiscal measures if required. While no changes were made, we recognized that at some point there will be an opportunity to take a more positive position into risk assets as valuations become more attractive.

Furthermore, we are monitoring liquidity in markets. We have observed liquidity dry up in some markets, particularly fixed income markets. The adoption of further quantitative easing by governments such as the US is aimed at providing such liquidity.

What next

We believe that it is important to remain invested during periods such as this, but portfolio diversification is important. We will be looking to further diversify our portfolios from a bottom-up investment perspective.

We will continue to monitor the situation as the market environment is evolving quickly. From a portfolio governance perspective, we will be holding more frequent investment committee meetings, and there is provision to hold unscheduled meetings as required. We will be providing further updates over the coming weeks.

Find out more

For more information on the Investment Committee work that we do for the Lonsec Model and Managed Portfolios, as well as other external consulting clients, please contact us on 1300 826 395 or info@lonsec.com.au. You can also find the latest insights via our website www.lonsec.com.au.

Sadly, the title of our Symposium now seems all too prophetic.

Following the advice of the Australian government and health authorities, we’ve decided that the best option is to cancel the event.

Over 900 people were already registered to attend, but we all need to help ‘flatten the curve’ and prevent the spread as much as we can.

At this stage we’re not planning to re-schedule, but we’re working to make the content available to everyone who registered. We’ll provide further information on how to access these materials as it becomes available.

Who knows, we may all have plenty of time at home to watch and read!

We’d like to thank our event sponsors, AllianceBernstein, Fidante, Fidelity, Investors Mutual, Legg Mason, Pendal Group, Schroders and Talaria, and we look forward to continuing to work with them to keep you informed.

Feel free to put the Lonsec Symposium 2021 (Thursday 29^th April 2021) in your diaries, and we look forward to seeing you all there, if not before.