What is happening?
In Australia, and globally, we have seen credit spreads increase markedly recently. (The credit spread is the difference between the baseline rate, and the interest rate provided by the security at its current price. In Australia, the baseline for most floating rate securities is BBSW (the Bank Bill Swap Rate); for fixed rate bonds it is generally the interest rate on an equivalent maturity government bond.) The following graph depicts the spread for 10-year A-rated corporate bonds. And it is notable that these bonds are not listed, and therefore not as readily re-priced.
In the hybrid market context, in many instances we see the trading prices falling below par (usually $100), resulting in a higher running yield. (Note: many clients are invested in hybrids as part of Fixed Income or Alternative allocations. We are not worried about the short term price movements of the hybrids we are invested in [other than as a buying opportunity, more on this below], as we are comfortable with the risk associated with the issuer and intend to hold to maturity / redemption - when face value will be returned.)
Why? And what it means
Increasing credit spreads can occur because of lower liquidity in the debt markets. For instance, in the listed hybrid market on our finance screens we see this in volume and price movements (small volume sales resulting in big price movements). So what is driving the lower liquidity?
The reasons are not readily or specifically identifiable, and are likely many. They include solvency pressures mounting in the oil and gas sector (driven by the oil price), concerns about debts being held by European banks, concerns about the outlook for China's growth and flow on impacts, and more generally, the overall level of debt and the sustainability thereof.
More generally, peaks in credit spreads can be an indicator of upcoming low economic growth, and of recession. It can also be an advance indicator of a market correction. Credit spreads, when not just a short-term spike, translate into the economy by a credit downturn - reducing the supply of credit and increasing the cost of debt, along with increased bad debts.
The degree of the current spread increase is significant, but that does not necessarily mean a recession will occur - the spread increase can reverse quickly. Particularly given the low liquidity environment. In this sell off (as distinct to other recent large events like the GFC and European crisis) it has not been as widely acknowledged, yet. Part of this may be due to the low base interest rates making the total return look less exciting in this sell off. A 5% spread in the GFC off a 6% interest rate meant a 11% income return. Today on a 2% base rate a 5% spread means only a 7% return. This may mean it takes a while for the market to "get" the bargains on offer today. Usually the market is pretty smart.
What it means for First Samuel
We are cautious. But most importantly - we are not predictors of the future (run away from anyone who purports to be). To manage the 'future risk', we examine each opportunity individually.
For fixed interest and hybrid investments, this means being comfortable with the issuer's ability to fund the interest payments, and return the face when it is due - even in difficult economic times. Short term movements can be weathered when you have this confidence. We have found opportunities in this recent sell-off to move our income portfolios back towards being fully (but not quite) invested, at what we think are very good prices (and future returns).
For the equity allocation, after reducing cash for several months (Nov-Jan), cash holdings currently sit at ~14.8%. We will await opportunities to arise. After the market rally from its recent low in mid February (XAO +8.5% since 12-Feb), we have not yet identified any further opportunities.
But it is not all fear and loathing. Far from it. We expect any credit spread related pressure on investment prices to present opportunities to buy (equity, hybrid and fixed income), at what will be favourable prices on a medium term view.