Income Report / Income Note: Infrastructure – a key beneficiary of last night’s budget (NABHA, DOW, IFL) **Portfolio Alerts - Income Portfolio - Sell Perpetual (PPT), Buy IOOF (IFL)**

By Market Matters 07 October 20

Income Note: Infrastructure – a key beneficiary of last night’s budget (NABHA, DOW, IFL) **Portfolio Alerts - Income Portfolio - Sell Perpetual (PPT), Buy IOOF (IFL)**

Market Matters Income Report 7th October 2020

Despite weak leads from the US overnight, Australian stocks are embracing the budget cash splash and rising modestly. Banks are edging higher and while we don’t cover in today’s not, more fiscal support is a boost for the economy and the banks are very much leveraged to broader economic trends. Theoretically at least, greater support for individuals and businesses will mean lower bad debts which is obviously a win for the banks. Institutions I speak with are all underweight the sector and that alone is a bullish backdrop. While low rates are a negative for margins, fiscal and monetary stimulus should provide a bigger tailwind for the sector. Commonwealth Bank (CBA) bets on ground today trading 0.7% higher.

Overall, the ASX 200 is currently trading up 25pts / 0.42% to 5988.

ASX 200 Chart

The Income portfolio underperformed in the last week with performance of -0.15%. Smart Group (SIQ) was the only significant drag on the portfolio falling -3.72%, while NBI, MXT & XARO all paid distributions. The portfolio remains well ahead of the RBA +4% benchmark this financial year, up 4.26% vs the 1.13% target.

NAB Hybrid (NABHA) – set for likely redemption

This is an interesting security and one that has divided opinion in the market for some years. As background, the NAB income securities were issued back in 1999 at a par value of $100, with a distribution rate of the 3 month Bank Bill Rate plus 1.25% per annum (unfranked) , paid quarterly.

This was a perpetual security meaning that it had no end date and has therefore traded more akin to NAB equity, however there was a ‘kicker’ in the conditions that suggested NAB would ultimately redeem these notes, the timing was the uncertain element.

The original distributions were unfranked and when the security was issued way back when, it qualified as Tier 1 regulatory capital for NAB, however, the level of that qualification reduced over time and would ultimately cease from 1 January 2022. Under Australian tax law, when the security no longer qualifies as Tier 1 capital, any subsequent distributions will need to be franked to the same extent as dividends on NAB’s ordinary shares are franked i.e. 100% The attachment of franking credits will not reduce the cash component of the distributions and given that the security no longer adds to the banks tier 1 capital, it would make it expensive in the eyes of the bank, and it’s a big issue at $2bn

Yesterday, the Board of NAB announced they will seek shareholder approval at its 2020 Annual General Meeting on 18 December that would allow it to repay the securities. While no decision has been made by NAB to repay the security, the assumption is that it will now be redeemed at the $100 face value plus any accrued interest.

The security rallied strongly yesterday on the back of the news.

MM are neutral NABHA and if we held we would use any move above $99 to sell

NAB Hybrid (NABHA) Chart

Infrastructure – a key beneficiary of last nights budget

Infrastructure development was a key component in last night’s budget with spending going from $100b to $110b over the next 10yrs providing a strong, longer term tailwind, however in the more immediate term the COVID-19 package is being beefed up with significant investments in major road and rail projects, road safety and community infrastructure with an additional $10b in funding bringing total commitments for new and accelerated projects since COVID to $14b. This is win for some players in the sector and we’ll use todays income note to focus on this area of the market, with one company in particular likely to be a key beneficiary.

The key areas of investment and companies exposed to this are: 

-          Additional $2b investment in ’shovel ready’ road safety upgrades : Key beneficiary – Downer EDI  (DOW)

-          Additional $1b to support local councils for immediate upgrades of local roads, footpaths and street lighting: Key beneficiaries – Downer EDI (DOW) & NRW Holdings (NWH)

-          Additional $2b in new funding to build vital water infrastructure across the country as part of national water grid including dams, weirs and pipelines – Key beneficiaries Cimic (CIM), Emeco (EHL), Downer EDI (DOW), Monadelphous (MND), NRW Holdings (NWH) &  SRG Global (SRG)  

-          Additional $250m to modernise recycling infrastructure to stop more than 600,000t of waste ending up in landfill – Key beneficiary Bingo (BIN) and to a lesser extent Cleanaway (CWY)  

-          Additional $1b of low-cost finance to support the construction of affordable housing – Key beneficiary Fleetwood (FWD)  

-          Investing $150m in the Indigenous Home Ownership Program to construct new homes in regional areas – Key beneficiary Macmahon Holdings (MAH)  

Downer EDI (DOW) comes out as a clear winner from the infrastructure announcements overnight. The engineering and infrastructure provider offers a broad range of services hence they feature in a number of the key areas above. Like many engineering / infrastructure companies, they’re relatively cheap trading on 13x forecast earnings, however it’s worth noting that it’s a tough business to operate in, with thin margins and high levels of project related risks where governments are now pushing more risk back onto the contractors.

As a yield investment, Downer offers a reasonable 3.20% fully franked yield, not too bad as official cash rates head to just 0.10%.

MM is bullish Downer EDI (DOW)

Downer EDI (DOW) Chart

**Alert** Switching Perpetual (PPT) into IOOF (IFL)

We’re increasing risk plus the potential for returns by switching from Perpetual (PPT) into IOOF (IFL). Given the relatively low risk composition of the portfolio, we see this slight tweak as offering good risk / reward despite crystallising a loss in PPT.

IFL is a very unloved wealth / funds management company which has recently bought MLC and raised ~$1bn in fresh equity. We believe that recent selling pressure has dried up and the stock has now hit an attractive accumulation level.

MM is switching from Perpetual (PPT) into IOOF (IFL)

IOOF (IFL) Chart

Conclusion

Downer is a key beneficiary of last night’s budget

We are switching from PPT to IFL

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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