Income Report / Income Note: How do lower rates impact Hybrids?

By Market Matters 12 June 19

Income Note: How do lower rates impact Hybrids?

Market Matters Income Report 12th June 2019

The ASX has opened higher again today, however the best of the session was seen early as the market pushed strongly up towards the 6600 handle, before sellers emerged. The miners benefited from strength in Iron Ore prices overnight, while Emeco (EHL) , a position we hold in the Platinum Portfolio is trading +15% higher after re-confirming earnings guidance. More on this in the afternoon note. 

Today’s trade has a very similar feeling to what played out in the US overnight – strength early but ultimately the market is now looking tired in the short term. A period of consolidation now feels likely.  

Currently, the ASX 200 is trading up  +12pts or +0.19% to 6558

ASX 200 Chart

The Income Portfolio had an strong week , adding +1.48% with broad based strength across the portfolio. The best performers were Perpetual (PPT) bouncing back to rise 5.7% and Estia Health (EHE) moving +4.2%. The portfolio also received dividends from CBAPF, CBAPG and NABPF through the week to aid performance. The portfolio continues to track over and above its benchmark of RBA + 4%. For the current financial year the portfolio has added 8.08% vs the benchmark at 5.09%, and since inception the portfolio is up 15.48% vs the benchmark of 10.63%.

For those interested in investing for income in a low rate environment, Market Markets does run an SMA which is open for investment. The portfolio is based on the MM Income Portfolio below. The SMA is now approaching its first anniversary and performance has remained sound. The Monthly Performance for May can be viewed here

How do lower interest rates impact Hybrids?

Hybrid securities have roared back into focus thanks largely to a Coalition victory at the 18 May Federal election and that has prompted a decent rally across the universe of hybrids. During May, the median margin over the bank bill rate across financial hybrids came in by 0.12% from 3.19% to 3.07%. This has combined with an obvious lack of supply which drives prices up on market. The next major bank hybrid needing to be refinanced does not have a first call date until 23rd March 2020 being the NABPC  -  supply is therefore tight and expected to stay that way for some time.

Hybrids however are floating rate notes, and lower interest rates mean lower returns from hybrids. Most hybrids are priced off the 90 day bank bill swap rate (BBSW) and pay a margin over it. As shown in the chart below, the BBSW has fallen sharply as interest rate expectations have changed. Given the median margin for financial hybrids is 3.07% and the BBSW is 1.37%, the median grossed yield to first call is 4.44%. That obviously includes shorter and longer dated issues however  the number has come in fairly dramatically over the last few months.

 Australian 90-day bank bill swap rate chart

You may have also heard about bank funding costs following the recent RBA interest rate cut and the decision by 2 of the majors not to pass through the full 25bp reduction. The argument being that over the course of the last few months, the cost of funds have declined substantially for the banks which would have helped them, and they should have passed on the full amount.

In terms of bank hybrids, there are two obvious ends of the spectrum as shown in the table below – both from CBA providing a good comparison of how the external credit environment can change. CBAPD was issued when demand was high, margins were slim and CBA could raise money at a margin of 2.80% over bank bill swap sits at one end of the spectrum, while CBAPE sits at the other. This was issued on a margin of 5.20% over bank bill swap when funding markets were tight, volatility was high, credit spreads were wide etc.

As we stand now, the market is calm and demand is strong, meaning securities are generally trading above the $100 face value to varying degrees. Those paying higher margins have obviously done better over time.

In terms of current value amongst listed hybrids, the below offers a view based of different durations to first call. The shorter dated notes are generally lower risk (less time for things to change / go wrong) while the longer term notes  pay a higher return. The below notes screen relatively cheap v their peers and duration.

While hybrids relative to other asset classes remain attractive, they’re generally not a compelling buy at current levels. As a rule of thumb, we tend to view a universe with a median margin amongst the financial hybrids at 3% as expensive, versus a margin nearer 4% as cheap.

Conclusion(s)

·         Hybrids yields are floating so the returns decline when interest rates drop

·         A lack of supply and a Coalition win at the polls has supported the sector, however its now expensive in our view.

Have a great day!

James, Harry  & 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.

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All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 12/06/2019

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