When bad news is good

PORTFOLIO POINT: Stockmarket investors are increasingly treating bad economic news as good in the expectation positive outcomes will follow. That remains to be seen.

Last week, a range of economic figures and overseas developments were announced. On Monday September 3 some particularly soft data was released and the Australian market moved accordingly. Figure 1 outlines the day’s action:

1. Positive overseas leads on the back of Us Federal Reserve chief Ben Bernanke’s promises to support the struggling US economy;
2. ANZ job ads were down 2.3% for August & retail spending fell 0.8% for July;
3. China: HSBC’s manufacturing index dropped to 47.6 in August (worst since Mar 2009);
4. 418 jobs were announced to be lost as part of the restructure of Darrell Lea.

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The above chart is in fact an inverted version of the actual day’s course of trades. In other words, as per figure 2, the market indeed finished up despite the day’s negative leads. It seems the market moved in the opposite direction to that which would seem rational.

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Perversely, it increasingly seems that bad economic news is being translated as ‘good’ by equity market participants as it is anticipated to be the catalyst to further stimulatory action by the world’s central banks. This is an unfortunate reflection of the way in which the perception toward equity market investment is shifting. That is, more toward a place to generate returns via short term price movements as opposed to that in which interested parties can efficiently allocate their capital toward businesses which will deliver the greatest returns on their investment over time.

The ECB last week announced the plans for the new ‘Outright Monetary Transactions’, which promises unlimited monetary support to the Euro region. While equity markets have held up following the announcements, it would seem that these forms of monetary stimulus are doing little to actually resurrect the developed world’s stagnating economies.

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As can be seen above, despite actions by US and UK central banks over the past four years to stem slowing growth rates and lower unemployment levels, the main beneficiary so far has been equity market participants as a result of the excess of liquidity being funnelled into stockmarkets.

Overnight US markets again rallied as the Fed announced it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month and hold the federal funds rate near zero at least through mid-2015. It was also announced that it will continue its purchases and undertake other efforts to help the labour market “if the outlook for employment does not improve.”

It is interesting to note that when Ben Bernanke first unveiled his quantitative easing policy it was designed to help stimulate the slowing US economy. While it worked in that it perhaps prevented worse outcomes, in January 2011 he cited a 20% increase in the S&P 500 as evidence of QE2’s effectiveness.

Given the uncharted and volatile global environment, we continue to invest with an eye on yield. This is not some new age way of thinking about investment, but rather a recognition that when market uncertainty is unusually high and prices of securities are extraordinarily volatile, a practical response is to construct part of one’s portfolio using high quality securities able to generate sustainable cash flows. 

ANZHA, NABHB and WBCHA - Tier 2 capital

Regular readers of this report will have noticed that I have held the recently issued ANZ notes (ASX.ANZHA) in my income portfolio since its inception in late April. ANZHA is a subordinated debt security of the ANZ Bank and it is classed as Tier 2 capital. Since listing in March 2012 NAB and Westpac have also issued similar Tier 2 capital securities.

Despite each bank’s initial intention to raise $500 million via the issue of their debt securities, a total of $4.36 billion was eventually raised due to the heavy demand by both retail and institutional investors. This is a reflection of the continued appetite for yield and regular income in the current economic environment. As the banks continue to move away from short-term wholesale overseas funding they have been happy to entertain excess demand for such securities.

Figure 5 provides a quick glance of the details regarding each security.

Figure 5: Details of the major banks recent subordinated debt offerings

Source: Respective Product Disclosure Statements

Based on the 90-day bank bill swap rate, these securities are trading at a running yield of 6.3%. I believe this is priced quite attractively given that:

• They are trading at about 330bp over the 10-year long bond at 3% (long end of the yield curve).
• A three-month term deposit offered by the major banks is currently around 4.5%. That is 180bp lower than these debt securities (shorter end of the yield curve).
• The major banks’ (ANZ, CBA and WBC) listed convertible preference shares (CPS) are currently trading at an average running yield of 6.8%pa. While these securities sit higher on the risk scale relative to the debt securities, the investor is only being compensated by an average of 0.5% pa higher in yield.

As a result, I believe these debt securities are a useful addition in one’s income portfolio. My view is that they are essentially similar, unless the credit risk of a particular bank deteriorates. At the time of writing, each of the banks is AA- rated. Qualitatively, I note that NABHB has consistently traded at the lowest spread amongst the three notes given it has been the smallest offer to date and, as such, the least available to investors. Additionally, NAB has not listed any hybrids for a longer period of time when compared to ANZ and WBC. However, I ultimately believe there to be no difference for ordinary investors and I would consider any as a suitable cash alternative depending on what is the cheapest at the time (that which offers the largest spread).

CBA PERLS VI – Tier 1 Hybrid

Last week, CBA lodged its widely anticipated Tier 1 hybrid offer to be known as ‘PERLS VI’.

The offer was announced with an expectation to raise $750 million with the ability to raise more or less. The PERLS VI hybrid securities are a perpetual, re-saleable, listed, subordinated, unsecured note paying quarterly floating rate distributions which are to be fully franked and non-cumulative with a call date in December 2018 and a mandatory exchange date in December 2020.  

PERLS VI will have an initial value of $100 and the proceeds of the offer will be used, to the extent necessary to refinance PERLS IV and fund the group’s business.

On Wednesday, CBA announced that it had already allocated $1.5 billion in PERLS VI (that is double the initial expectation) under the broker firm offer with the margin to be set at 380 basis points (bp) over the 90 day bank bill swap rate.  

I believe this is the first of the new type of Tier 1 hybrids to be issued by a major bank in Australia under the BASEL III framework. Under the framework there is a ‘Non-Viability Trigger Event’ whereby BASEL III qualified Tier I hybrids must be able to absorb capital losses. As a result, I believe that new hybrids issued under this framework are of higher risk when compared to the existing older style Tier 1 hybrids. As such, they will require a much higher margin to compensate investors.

Whilst it is very unlikely that CBA will be forced to enact this Non-Viability Trigger Event, I believe that the 380bp margin is not high enough to compensate for the higher risk one would be undertaking to hold these securities. At 380bp, this new Tier 1 hybrid is less than 40bp above the existing (and lower risk) Tier 1 hybrid securities on the market.

I would prefer to consider them once they are listed, and the opportunity to purchase them at a greater yield may present itself.

Clime Income Portfolio

Start Value: $118,757.19

Current Value: $125,177.70

Average Yield: 8.65%

Weighted Portfolio Return

Since Inception (24 April 2012): 4.31%

Since June 30, 2012: 5.41%

Market prices as at close August 13 September 2012. Purchase price as of close June 29, 2012.

John Abernethy is the chief investment officer at Clime Investment Management. Register for a complimentary portfolio assessment.