PORTFOLIO POINT: With the troubles in Europe and the US causing the $A to rise, and bond yields still low, Australia’s economic strategy should be focused on issuing more debt.
The recent recovery in overseas equity markets does belie the economic indicators, which range from depressing in Europe to weak in the US.
The lift in share prices followed the statements of Mario Draghi, the President of the European Central Bank (ECB), that the ECB would do “whatever it takes” to support the euro. When the German, French and Italian leaders echoed that statement, then the seeds were sown for a “short” covering rally across Europe.
The extent of shorting across physical and derivative markets is never clear, but it seems logical to assume that European banks and traders had tended to be short investment assets given the current European environment.
So what does “support the euro” mean? Well, as is usual in Europe, nobody actually knows, but speculation is rampant that the European Stability Fund and the ECB will act in unison to stabilise or lower the bond yields of both Spain and Italy. The statement was made at an Olympic opening economic briefing event (that is not a joke), and so we should all hope that the president was not tipsy at the time. In any case, it is a given that stabilisation of bonds requires quantitative easing and so the euro printing presses are switched on again.
The comments seemed to have caught the Bundesbank by surprise. The Bundesbank is a key stakeholder of the ECB and it is suggesting that the ECB has no right or power to intervene in bond markets. That is a strange view to take given the balance sheet of the ECB has ballooned above €3 trillion and is full of European government bonds!
With the ECB having made such a strong and unequivocal statement, we now have to watch developments very closely. Any lack of decisive follow through or disputation amongst key European leaders will lead to a sharp correction in European equity markets and flow into the US. There is thus little wonder that Timothy Geithner, the head of the US Treasury, is back in Europe to force through the policies. We continue to see an anaemic recovery in the US as Europe’s woes continue to be a major economic headwind.
Meanwhile in Australia, the effect of more quantitative easing in Europe, and the threat of the same in the US, is causing more upward pressure on our currency. The relationship between our terms of trade and our dollar value is breaking down. It reinforces my strong view that the Australian government must develop strategies to counteract the economic policies of Europe and the US. Last night’s negative market moves were a case in point.
Frankly, a lift in the $A to above US$1.10 is awful for the Australian economy. Weakening commodity prices should result in a weakening of the $A to offset our weakening trade account. The natural economic stabiliser of a floating $A works when major offshore trading partners are not interfering with the value of their currencies. It isn’t working now and it demands a response from our government and our RBA.
With the $A reaching a record high of €85 it seems likely that we will lift further against sterling. I suspect that the pound sterling will plummet after the Olympics as the full scale of its economic woes become clearer. Against the $US we have lifted again to about $1.05, and the consequences of this on our exchange rate with China does not seem well understood because the Chinese are pegging their currency to the $US. It is just not fair that the $A should appreciate against that of the fastest-growing country in the world.
The reasons as to why the $A is strong and our bond yields are low is not something to be blindly proud of. It is a reflection of both the poor overseas economic environment and their monetary policy responses. So rather than bask in some sort of short-term glory, we need to assume that the good times won’t last and seize the moment. That is exactly what many financial controllers are doing when they access debt, hybrid and equity markets for their companies.
Figure 1. Australian yield curve
Last week we outlined some strategies that could be adopted by our government. One key opportunity is currently presented by the historically low Australian bond yields. Based on current international demand (for example the desire of the Swiss Central Bank to buy $A) it seems that Australia could actually raise 10, 15 and 20-year debt at average yields of about 3.25%.
This is a unique and unprecedented opportunity, so let’s examine the potential.
Say the government raised $100 billion at 3.25% with an average maturity term of 15 years. The interest cost on this debt would represent just 0.8% of the total federal government revenue of $370 billion in 2012-13. It is a relatively small amount of interest but it is a massive amount of capital (about 27% of budget expenditure) that could be raised to undertake many significant national projects including the following:
- Build the NBN;
- Complete the dual carriageway between Sydney and Brisbane;
- Build a second Sydney Airport;
- Upgrade every public hospital facility in Australia;
- Provide funding to the NSW state government to fix Sydney public transport;
- Build a decent road from Perth Airport to Crown’s new 6-star hotel; and
- Replace more expensive government short-term debt.
The raising of $100 billion of debt to invest in productive assets may raise our gross government debt by say 6% of GDP, but it will lift our national asset base. From a Commonwealth balance-sheet perspective the underlying net debt does not rise if assets are acquired or developed. The risk of higher debt with comparisons to Spain, Greece and Ireland are illusory because their debt evolved from excessive social services and banking collapses. It was not debt that was raised for productive investment.
Is the Caltex hybrid attractive for our income portfolio?
As noted above, the best corporate treasurers will constantly review their financing arrangements. They will monitor the cost of debt or equity and maintain a desirable debt maturity profile.
From an investment perspective, the investor must be cognisant that the issuer of debt is attempting to attain the best terms for themselves. On that basis a healthy level of enquiry should be undertaken before a new debt or hybrid issue is subscribed for.
The power between issuer and purchaser shifts because of market sentiment, yield momentum and the perceived investment outlook. For instance, issuers have an advantage when there is a strong desire for investors to seek yield and discount growth. I suspect that is the current market environment.
That environment helps the Australian government raise very low-cost fixed-rate debt – should it desire. However, low-yielding long-dated bonds are not good investments, at this point, for Australian investors. Current bond yields do not offer adequate returns for retirees and the risk of inflation is currently underestimated.
The market environment does support listed corporations who can access low-cost long-term funding and the current hybrid issue by Caltex is a case in point. This issue has some good features and some less positive features.
The good features include:
- The possibility of redemption at five years from issuance gives the hybrid a quasi debt feature;
- The cumulative nature of the interest payments where missed interest must be made up and a dividend stopper are both excellent supportive terms; and
- The lack of a gearing limit that would normally halt distributions is also supportive.
The main negative for an investor is the potential for the issue to extend to 25 years. Should this option be taken by Caltex, then holders of their hybrids will hold a security that takes on the timeframe of equity without a commensurate potential return. The opening floating yield of about 8% does not appear high enough for this long-dated scenario, and so it is not considered as an attractive investment for our income portfolio.
Given the recent decision of Caltex to close refining plants then it is not clear what Caltex will look like in five, 10 or 25 years? So our portfolio will review Caltex hybrids in the aftermarket over the next few months. With a few more new hybrid issues likely for the market in coming months, investors may be spoilt for choice and yields may actually rise.
The Income Portfolio
Start Value: $118,757.19
Current Value: $124,140.69
Hybrids/Pseudo Debt Securities
Margin over BBSW (%)
Floating Rate Note
|NAB Floating Rate|
Total Return (%)
* Market prices as at close August 2, 2012. ^ Purchase price as of close June 29, 2012
John Abernethy is the chief investment officer at Clime Investment Management.
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