Wry & Dry

Investment Matters

The markets

Markets 18 12 15

The most anticipated interest rate rise in history occurred this week with the US Federal Reserve electing to raise interest rates for the first time in nearly a decade.  The rise was so well telegraphed that the US market mostly shrugged off the news, finishing the week only slightly down.

The local market had a volatile week, falling heavily early in the week before rallying strongly off market lows, to close the week more than 1% higher.

US interest rate decision

Equity markets around the world have shrugged off this week's US Federal Reserve (central bank) decision to lift rates by 0.25% - off their record lows.  In fact, there was really an expectation that it would proceed, and markets could quite well have taken the news badly if rates weren't increased.  This is because, given the current quite positive US economic data (including employment), not raising rates would have signalled a lack of faith in the US economy.  Additionally, we believe equity markets were ready to recognise that ~0% rates are not ideal for long-term risk pricing of assets (of all various forms).

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.

Corproate bonds

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

4. Today

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

Company news

It has been quite a busy week on the news front - for a time of year that is normally the opposite.

Heemskirk conducted a capital raising to fund completion of Stage 1 of the frac sand project in Canada (including working capital), and to finalise the complete debt and finance needed through to Stage 2.   We participated in the raising on your behalf.  Whilst it is somewhat disappointing that this has been required, it does help further de-risk the business.  And the highly discounted nature of the offer, combined with the strong financial metrics and market position of the project, remain very attractive. 

Ingenia Communities acquired a new MHE (manufactured home estate) park on the mid north coast of NSW; located within an existing cluster.  Approvals are in place for 52 new homes.  This provides opportunity for development profits, in addition to the normal annuity style rental income stream usual for these villages.

Emeco purchased US$52.3m of its own US-based debt, at 60 cents in the dollar (this ties into the debt discussion above, with some of the US debt holders preferring to lock in a certain return given the current difficult conditions for US low grade debt, rather than wait to the debt maturity in Mar-19).  This will reduce the company's interest cost by ~$5.2m per year.  Proceeds from the partial closeout of an in-the-money interest rate swap were used to fund the debt purchase.  We see this as a positive development for Emeco, as it has strengthened the balance sheet of the company markedly.  In addition, it has boosted the book value per share of equity by 19% (to $0.44ps from $0.37ps).  This compares to a current share price of $0.042cps, or 9.6% of its net asset value.

Origin Energy's LNG project commenced production last Friday.  The first shipment to Asia is due by the end of the year.  Although the timing isn't ideal in relation to the oil price, this marks the end of a major investment by the company, removes construction risk (real and perceived), and will turn the project from a cash drain to a cash generator.

The mid-year government budget (MYEFO) contains savings that are anticipated to impact on earnings from Primary Health Care's pathology and radiology divisions - should the government's proposals get past the Senate.  As has been articulated by competitors, we expect Primary to increase its use of co-payments to compensate for the reduced government funding and short-term volume declines.

Suncorp released a downgrade to its expected underlying insurance margin for the half ending 31-Dec-15.  It is now forecast to be 10%, versus 14.8% for the prior comparable period, and an ongoing target of 12%.  The main driver was increased claim costs in personal and commercial lines, with an increase in the natural hazards allowance and lower investment returns also impacting.  The lower margin will lead to a lower profit for the company. The company is implementing operational changes to bring its claims costs under control and remains committed to its 12% insurance margin for FY-16.

  -       Fleur Graves