12 December 2017
David Hanna, Portfolio Manager, Macquarie Fixed Income
Using nautical metaphors to describe how to invest in financial markets might sound cliché. However, with credit spreads tightening towards post crisis lows over the last eighteen months it seems the metaphor is more appropriate than ever. When entering a shallow body of water a captain and crew’s ability to avoid hazards, like dangerous reefs, is the skill you rely on to make it back to port safely. With the global chase for yield continuing and valuations getting stretched, the same applies to the skills and resources of credit portfolio managers and analysts, where managing idiosyncratic risk is key to avoiding losses.
Valuations getting richer
In early 2016, falling commodity prices and widening high yield credit spreads suggested the world was heading toward a recession. Thanks to combined central banks’ support and stimulus in China, the global economy recovered driving improving fundamentals and supporting a cyclical uptick in growth. With the improvement in general market sentiment and a chase for yield in financial assets, valuations have edged gradually towards the expensive end of the range. This has seen credit spreads in investment grade credit tightening from their highs of around an average of 200bps in early 2016, to 100bps in October 2017, with moves more pronounced in higher beta sectors like high yield and emerging markets. High yield, for example, has seen spreads tightening from over 850bps (the widest since 2011) to below 400bps. For both high yield and investment grade credit, current levels are approaching the post crisis lows that had been reached mid-2014.
Historical credit spreads
Source: Bloomberg, November 2017
Impact on the Australian credit market
In the Australian credit market a key effect of the chase for yield has seen investors looking at new foreign issuers, longer dated, lower rated or less liquid credit and investing in structures that in the past, they may have had limited exposure to. We have highlighted below two structural changes occurring in the Australian credit due to these behaviors.
Foreign corporate bonds
With this broadening market and relatively cheap cost of financing for international corporates the Australian market has seen a number of new offshore issuers arrive to take advantage of local conditions offering them relatively cheap financing compared to historical levels. These AUD bonds issued by non-Australian firms in the Australian market are called Kangaroo bonds.
Issuers in the Australian credit market
Source: Macquarie, October 2017
As these issuers generally offer excess spread over an equivalent Australian corporate, investors have been attracted to the modest discount on price offered by these issuers.
Longer dated issuance
The Australian credit market has seen a greater amount of over 10 year issuance. The attraction here is again extra yield for taking longer dated credit risk.
Over 10 year corporate non-financial issuance in Australia
Source Macquarie, October 2017
On the “look-out” for opportunities and hazards
When combining these structural changes we see both opportunities and threats as investors might not always have the experience or resources to price these new risks appropriately.
When analyzing the credit curves of issuers in our market, we have noticed the Australian curve is often flatter when compared with offshore markets. This implies that relatively speaking investors are taking on greater credit duration (credit risk), by going into longer maturities, to gain less additional return in Australia. If a strategy has the ability to invest in these same names offshore, this is a better alternative from a risk reward perspective.
Spreads on Apple bonds
Source: Macquarie, November 2017
Beware of the shallows
But we should never forget that credit risk is asymmetric and that our focus should always be about avoiding the downside. Avoiding hazards in this environment is even more important. Using the sailing metaphor again, the less water between your boat and the bottom of the sea, the more likely a small steering mistake might result in hitting an unexpected hazard. The same goes with credit spreads. As spreads continue to tighten, the relative impact of an idiosyncratic event occurring to an individual name is greater. Simplistically, getting calls wrong imposes tougher penalties. One recent example, which we avoided, has been the impact of poor third quarter earnings for Teva Pharmaceutical Industries Ltd. The credit spread on its USD denominated bonds maturing October 2026 widened by over 125bps, which in the current low yield environment is over 3 years of carry (between 1st and 13th November the bond price went from 88.50% to 81.35% with the credit spread on the 1st November at 237bps).
Spreads on TEVA bonds
Source: Bloomberg, Macquarie, November 2017
Staying true to our investment philosophy which is focused on capital preservation (avoiding the losers in credit), a strong respect for liquidity risk and fundamental research, is therefore more important than ever in these market conditions. To take advantage of offshore opportunities and mitigate idiosyncratic risk, our fixed income strategies that invest in credit markets can also leverage from a large team of global credit analysts and portfolio managers with the experience to navigate those markets.