Income Report / Income Report: Are we finding income opportunities amongst Hybrids? (NAB, TAH)

By Market Matters 14 August 19

Income Report: Are we finding income opportunities amongst Hybrids? (NAB, TAH)

Market Matters Income Report 14th August 2019

The local market was strong early however a combination of weaker than expected Chinese economic data plus a lower yuan fix re-invigorated the sellers and the market is trading down around 30pts from the early highs. CBA is trading ex-dividend off by $2.64 / 3.32% at $76.82 with the dividend worth $3.30 inclusive of franking. Elsewhere, CSL is trading up +5% on a result that was largely in line with expectations although their guidance for profit of between  $2.05b -  $2.11b was ahead of market expectations of $2.04b for FY20, which is a ~2% beat. Shares are trading at $231.91 at time of writing.

Unloved Pact Group (PGH) is feeling pain today off by ~20% re-testing recent lows. The result was broadly in-line with expectations, however the guidance for modest EBITDA growth in FY20 conditional upon market conditions may have spooked some. The market was looking for a rebound in earnings of +7.5%, so the issue is around what ‘modest’ means along with the caveat around economic conditions. Gearing is also high which has been well documented and understood, however on a forward P/E of 9x, this is a value play which is undergoing a choppy turnaround. We remain keen on PGH despite the weakness today. More in the afternoon note.

At lunchtime today, the ASX 200 is trading flat at 6567.

ASX 200 Chart

The Income Portfolio had reasonable week, climbing 0.57%. The biggest mover was IVE Group (IGL) which added +4% while GMA went ex-dividend by 30.9c, the ordinary dividend was franked while the special dividend was not. The portfolio is underperforming its absolute return benchmark financial year to date down by -0.35% vs the benchmark at +0.59%. Since inception the portfolio is up +15.76% vs the benchmark of +11.51%.

For those interested in investing for income in a low rate environment, Market Markets does run an Separately Managed Account (SMA) which is open for investment. The portfolio is based on the MM Income Portfolio below. The SMA has now passed its first anniversary and performance has remained sound.  The July update can be viewed - Click Here.

NAB (NAB) $27.54

NAB provided a quarterly trading update today that implies they’re on track to meet full year expectations.  Here are the highlights:

Reported $1.65B cash profit in 3Q19 with  1% revenue growth and no change in expenses from the quarterly average of 1H19 to 3Q19. Net interest margins improved due to lower funding costs which has been a trend across the banks in recent times. The bad debt charge increased slightly to $247M in 3Q19 and past due loans also continued to increase due to mortgage delinquencies, but not materially so. Their capital position is reasonable at 10.7% after the inclusion of the dividend reinvestment plan.

MM is positive NAB for yield & it remains a core holding in the income portfolio

NAB Chart

Tabcorp (TAH)  $4.37

TAH reported FY19 results this morning and they were broadly in-line with expectations:
Top line revenue of $5.48bn was slightly ahead of the $5.41b expected as their lotteries business continued to flourish. Net profit after tax was $397.6m, a whisker ahead of the $396.9m expected while the all-important dividend came in at 11c for the half taking the full year to 22cps fully franked, putting it on a yield of 5.04%, or 7.2% gross, which is a 100% payout of net profit.

It’s the first full year where the Tabcorp-Tatts merger has been reported and we continue to believe TAH offers a defensive earnings stream, attractive yield at a reasonable valuation.  

MM is positive TAH for yield and it remains in the income portfolio

Tabcorp (TAH) Chart

Australian interest rate futures are pricing in a forward cash rate of 0.57% by December this year and it seems very clear that interest rates remain the key to the health of the share market medium-term. Markets are becoming increasingly comfortable with the “zero interest rate” thematic which has implications for asset prices generally, but particularly income producing assets. Finding sustainable income in a low rate environment to maintain spending power is now a serious challenge for many Australians, and hybrids are an asset class that can assist here.

In today’s note we’ll look at Hybrids that offer sustainable, albeit lower yields to equities looking for opportunity in a hot market.

Are we finding income opportunities amongst Hybrids?

There are two trains of thought in hybrids at the moment which can be distilled down into thinking they are cheap or expensive, much the same as current thinking around stocks. From an earnings perspective relative to historical measures they’re expensive, just like stocks are however relative to alternatives (like cash), they’re cheap - always remember that investing is a relative game.

Hybrids are structured as a mixture of debt & equity, so they have both debt and equity characteristics and can therefore be influenced by both markets. In the last month we’ve seen a broad contraction across credit markets, including hybrids which has meant hybrid prices have been strong. We’ve also seen a strong move up in equities as record low cash and bond yields continues to fuel investor appetite for asset classes outside of cash in order to generate sufficient income  - Hybrids have certainly benefitted from that reallocation up the risk spectrum.

The average margin across financial hybrids has dropped from 2.39% to 2.26% in the past month so when added to the current 90 day bank bill rate, this tells us the average yield on a financial hybrid is  3.21% including franking.

Because prices have rallied strongly, putting pressure on yields, it’s now hard to get excited about buying hybrids in a general sense, however it’s also fair to say that the lack of alternatives for yield means selling hybrids at these levels is also pretty unappealing. That means that small incremental buying has continued to support the market, and that will likely continue.  

Interestingly, when we last produced the below chart about 6 months ago, the margins were above the total yields being offered today, which gives some insight into the contraction of yields.

Below we look at the returns of financial hybrids with greater than 3 years to maturity. The longer the duration the greater the yield should be. Going out greater than 3 years should yield a grossed up return of ~3.50% to first call.

Hybrid returns with 3+ years to first call date

The following are the best ‘relative’ picks although again, hard to get excited about these numbers:

Majors: ANZPF: A tier 1 hybrid security of a major bank offering 3.50% to first call in 3.5 years.

ANZPE Chart

Regionals: BOQPE: A tier 1  hybrid security of a regional bank offering 3.87% yield to first call in 5 years

BOQPE Chart

Other: MQGPD: We hold and continues to screens well in a relative sense offering 4.11% yield to first call.  

MQGPD Chart

 

Current Hybrids in the MM Income Portfolio

Conclusion

Hybrids have rallied strongly compressing yields and look expensive relative to history

We are retaining our current weightings / holdings, but not increasing them at this stage.

If pressed to buy, we would add ANZPF, BOQPE or MQGPD  

James & the Market Matters Team

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

Disclaimer

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