In recent months we have seen two high profile listed hybrids come to market, Westpac Capital Notes 5 (WBCPH) and CommBank PERLS X Capital Notes (CBAPG). Both of these were oversubscribed however we felt that their offer for yield was insufficient for us to participate. There are many factors to consider when investing for yield, and when you are seeking more yield you have three choices; i) extend tenor, ii) move down the credit quality spectrum; and iii) move down the capital structure. In the case for WBCPH and CBAPG (and other recent IPOs), the tenor has been extended to seven years or more, without the necessary pick up in margin over the 90-day Bank Bill Swap Rate. To understand this, we set the scene below and explain why we didn?t participate in the offer.
Setting the scene:
In the most recent economic update, I commented again on the continued economic growth that we have been experiencing for over 12 months. Leading economic indicators continue to point to a strengthening economy through 2018, with inflation remaining benign. Easy monetary policy is slowly coming to an endwith the US Federal Reserve now firmly in a tightening cycle and Europe removing the words ?further easing? from its policy statement at its recent meeting. In Australia, the Reserve Bank has retained the ultra- low 1.5% rate and is likely to do so for the remainder of 2018, while setting the scene for a rate hike.
In the US, Jeremy Powell, newly appointed chairperson of the US Federal Reserve, painted an optimistic picture of the US economy and even pointed to risks of the ?strong? outlook. Some key takeaways:
- accelerating US expansion is occurring during a “moment of global growth”, when headwinds have shifted to tailwinds.
- with the unemployment rate at a historically low level and the labour participation rate not moving up much, Powell expressed confidence that wage growth would pick up and that the recent shortfall in inflation would prove transitory.
Unsurprisingly this week the US Federal Reserve raised rates by 25bpts. The official cash rate in the US is now higher than the official cash rate in Australia. While this has occurred in the past it has not been frequent.
The prospect of higher US inflation has caused US bond yields to push up erratically on the assumption that the Fed will need to increase rates faster. The risk is that bond yields push higher on more strong US economic readings and more signs that inflation is increasing. The market had been assuming 3 rate hikes and possibly 4. U.S. short-term rates are likely to be above Australian short-term rates for a while: 3-4 Fed hikes versus potentially no RBA hikes for 2018 and we could have 100bps of difference between our cash rates. Note that the cost of funding for the banks in the US has already risen by about 50bpts so households are about to start feeling like they have already had 3 rate hikes!
In a previous note to clients in November 2014, I outlined our preference for hybrids over senior credit in searching for yield. To reach for yield one can ?i) extend tenor, ii) move down the credit quality spectrum; and iii) move down the capital structure. Moving into high yield / sub-investment grade doesn?t makesense……… Extending tenor doesn?t make sense in our view either, a combination of poor relative value(we continue to like the 3-5 yr maturity buckets) and spectre of US rate rises pushing 10 year yields highermay erode the majority of the term spread pick up. We continue to prefer to move down the capital structure and advocate overweighting AT1s and T2s in bank capital and sub notes in investment grade (IG) corp debt on risk/reward.
Here we have the Australian 5-year iTraxx (Source:Bloomberg). It is generally?regarded as a proxy for domestic?credit spreads. As you can see,?during March, credit spreads?have widened. This does not?bode well for the CBAPG listing.?2016 and 2017 however were a?boon for listed income?securities, in fact it was hard to?go wrong. Equity markets were?experiencing a prolonged period?of low volatility and?complacency was creeping in.?Just take US equity market
valuations now topping 19xPE?compared to the long run?average of 15xPE. This low volatility environment led to a tightening of credit spreads. This seems to have reversed and will impact longer dated interest bearing securities the most.
Despite these incremental rate increases in the US, interest rates globally remain exceptionally low keeping investors firmly entrenched in a chase for yield. This was quite evident recently when both Westpac and Commonwealth Bank issued two new listed hybrid securities.
The offer, and why we didn?t participate:
Westpac came to market in February 2018 with WBCPH offering an indicative margin of 3.20% to 3.40% over the 90-day Bank-bill swap rate (BBSW). At the time the 90-day BBSW was 1.80% thus equating to a gross running yield of 5.00% to 5.20%. It?s important here to also look at the term of the investment, Westpac was offering a term of 7.5 years with an option for another 2. Shortly after, the Commonwealth Bank came to market with CBAPG. Commonwealth Bank was offering 3.40% to 3.60% over the 90-day BBSW which was a little more attractive compared to the Westpac offer. The term being offered was also a fraction shorter at 7 years with an option for another 2.
Within the Royston Capital Interest-Bearing Securities portfolio, we choose not to participate in either of these offers. I do note that both were well supported and over-subscribed. This is not surprising given the reduction in supply of new issues, general investor demand for yield, and listed Exchange Traded Funds (ETFs) and fund managers who all need new issues to add depth and liquidity.
Our view for the WBCPH and CBAPG was that yield on offer was not sufficient for the time in which we would need to be invested. The chart below illustrates the issue margins of many of the listed income securities in date order. You can see the recent peak in margin was with CBAPE and the margin on offer has since been in steady decline. We simply didn?t see value in what was being offered and were of the viewthat the WBCPH was at risk of listing at a discount to its face value (which we have since been proven?right). WBCPH?s low margin and 7.5yr term was a double whammy for investors offering poor relative value. We believe that the CBAPG will also suffer a similar fate.
Source: Royston Capital
When we look at trading margins we start to see a clearer picture. WBCPH was issued at 3.20% and CBAPG at 3.40% over the 90-day BBSW. WBCPH has commenced trading and is illustrated as the dot furthest to the right on the chart below. Our objective when viewing this chart is to seek the best return for the duration. Excluding the early issues of CBA PERLS, all the listed income securities are issued with a $100 face value and at call that $100 is returned to us. As we approach the 1st call date for the listed income securities we have a greater certainty about the price of the investment and thus the level of risk reduces. Anyone who has subscribed to the WBCPH and CBAPG will need to ensure they have done so for the long term to avoid realising any immediate capital loss. For those that did not subscribe to them, then there may be an opportunity to buy in on market at a more attractive price…. perhaps soon. For now there are some attractive yields with tenors of 3-5 years that are of interest.
Source: Royston Capital. As at 22/3/18
US rates are highly likely to rise further this year and we will see the gap between US and Australian official cash rates widen further. The easing bias for the RBA has gone and they are still waiting for the right time to increase interest rates without causing a property market crash. Investment markets have become more volatile this year, as investors adjust to a world moving past the end of an era of never seen before monetary policy and into a rising interest rate environment. This, increased volatility in equity markets is causing credit spreads to widen which is a risk for complacent investors in the chase for yield. This is a time to dig a little deeper, research the opportunity and wait for your moment to invest, for there is no benefit in chasing yield at the expense of your capital.