The end of free money
The extended period of low interest rates, combined with quantitative easing (money printing in effect), has led to high amounts of liquidity in debt markets generally. Until late this week, global share-markets have been undergoing a short-term selloff. We view this as being led by debt markets, and from the US particularly. The prospect of higher interest rates was the core driver of this turmoil in debt markets.
For this week's W&D we provide some perspective around what is occurring in Australia.
Whilst we share (and in fact have led) most of the same concerns that commentators have around debt markets – being liquidity, credit quality and the sheer quantum of debt out there - it is worthwhile putting these things in perspective.
Above is a graph of BBB grade Australian corporate debt yields less the Bank Bill Swap rate for 5 year term debt for the past 10 years (not including financial companies). Here you can see several key periods.
1. The 2005-July 2007 remarkably low credit spread period (building into the GFC)
2. The GFC, where initially spreads blew out to 200bps and the took off (albeit briefly) to 850bps post the fall of Lehman Brothers
3. The recovery period that then led into the 2012 European debt crisis
What is apparent is that there has only really been two periods that have had greater spreads than today in the past 10 years. In fact, if you don’t believe that the markets will seize up completely (as per Lehmans), the best analogy is the European debt period (whereby it felt like Europe was going to fall over and a global recession was possible).
In this period spreads approached 285bps (versus ~260bps today, probably higher if you actually tried to transact).
So in light of this, it is reasonable to say that the debt market is already pricing in a “bad” credit environment (being higher defaults). Actually, it is pricing in line with as bad as was expected (but didn’t eventuate) for the European crisis.
It is, however, nowhere near the extremes seen at the time of the Lehman Brothers collapse. A similar situation is a possibility, but we consider it unlikely, and it was also a relatively dramatic, short-lived event.
Because we are long-term investors, we have found this environment and spreads too tempting. Therefore, late last week we moved back to being fully invested in clients' Income Securities allocations. This is the first time, for some time, that this has been the case.
We remain very cognisant of credit risk, which is why we remain largely clear of the banking/financial sector. We focus on the gearing of the underlying entities in which we are investing, and their general business strength. The Income Securities allocation is expected to generate a cash running yield of 6.5%, which is a 4.2% margin over 90 day bank bill swaps and 5 year government bonds, and 4.5% over the RBA cash rate.
These are very good margins, and will go a long way to helping our clients achieve their CPI+ goals over the medium-term.
- Dennison Hambling