Income Report / Income Note: MM’s current thoughts on our income securities (AMPPB, WBCPI, MXT, XARO, NBI, LQD US, HYG US, CBA)

A positive move in equity markets today with the ASX piggybacking off overseas strength. At lunch, the market is 1% higher at 5953 with telcos, tech and consumer names pacing gains while all sectors trade higher. As we wrote last week, buyers of weakness remain strong with the index continuing to remain range bound between 5700/6200. Seek (SEK) is currently the best of the lot on rumours their Chinese operations are getting the attention of Alibaba with share’s in the job classifieds business up over 9%.

Overall, the ASX 200 is currently trading up +58pts/ 0.99% to 5952.

ASX 200 Chart

The Income Portfolio was off marginally during the week though the -0.58% performance of the portfolio was far better than the ~1.8% fall on the accumulation index. There were no dividends during the week, while allocation to the banks were the main drag on performance – CBA -5% and NAB -4% across the sessions. The portfolio is up +3.45% FY21 to date with the benchmark (RBA + 4%) sitting at 0.88%.

What are our current thoughts around our income securities?

Interest rates are low and looking at the outlook for bond yields they’ll stay low for an extended period of time. Couple that with a sharp reduction in dividends thanks to COVID and the outlook for income is a ‘challenging one’ to say the least. Last week we penned a contrarian note on Telstra’s dividend, this week we’ll set out our views around income securities and touch on what banks will need to do to improve from currently depressed levels.

While interest rates will stay lower for longer in MM’s view, at current levels it seems an obvious observation to make that there is further upside potential to rates than downside potential over time. If we buy a fixed rate of return now (like a fixed rate bond) and rates rise, the capital price of that security will decline.

For that reason we think it’s important to hold primarily floating rate securities rather than fixed rate securities at this time in the cycle, particularly when buying longer dated income streams.

Hybrids are an obvious option and while investors have mixed feelings about the complexity of hybrids being a mixture of debt and equity, its hard to argue that the sector has just had a meaningful test and today is back trading at all time highs as shown through the Hybrid Index below – clearly a positive.

MM remains positive on Hybrids  

Solactive Hybrid Index Chart

We currently hold 4 hybrids in the MM Income Portfolio, all of which offer floating rates over the 90 day bank bill swap rate.

AMPPB: This is a higher risk security, however less so than is being priced by the market in MM’s view. The security offers a yield to first call of 5.63% with 5.3 years to run. We view this as cheap

AMP Hybrid (AMPPB) Chart

CBAPG: This is a lower risk security offering a yield to first call of 3.49% with 4.6 years to run – around about fair value

MQGPD: This is a moderate risk security offering a yield to first call of 3.69% with 6 years to run –  this security screens at the expensive side given Macquarie’s risker exposure and weaker capital position relative to the majors. NB: We are considering moving out of the MQGPD into the WBCPI below.  

NABPF: This is another low risk security offering a yield to first call of 3.56% with 5.8 years to run – around about fair value

While we don’t own the WBCPI this is an interesting security offering 3.41% with 3.9 years to run. This is a shorter dated security relative to the names above, and is lower risk.

MM is positive the WBCPI

Westpac Hybrid (WBCPI) Chart

We also hold the MCP Master Income Trust (MXT). When they listed back in 2017, they were the first sort of listed vehicle tapping an alternative style income market, in this case being domestic corporate loans, so sitting alongside, or in place of banks, lending to Australian corporates. Over that time, MXT has been a consistent performer, they experienced more volatility in March in terms of their share price than we would have thought they would / should however that is a function of liquidity rather than anything else, and the ‘get me out’ mentality at any price that was obvious at the time.

MXT target a rate of return at 3.25% above cash and are currently paying a consistent yield slightly above 5%.

MM remains positive MXT

MCP Master Income Trust (MXT) Chart

Amongst bonds, we have 2 positions both of which are slightly ‘off-piste’.  

The ActiveX Ardea Bond Fund (XARO) is a  bond fund which uses a relative valuation strategy targeting high quality government bonds with 70+% exposure in Australia. They actively manage exposures through buying relatively cheap bonds and selling relatively expensive bonds, therefore eliminating risks around interest rate duration which is obviously a major consideration when investing in bonds at this low point for global interest rates. The managers have a strong track record over the past 10 years, they manage around $13b across fixed income markets and many well-known Australian Institutions invest with them. It’s a lower risk strategy with a return target of CPI +2%, although they paid a 4.8% yield over the past 12 months.

MM remains positive XARO

ActiveX Ardea Bond Fund (XARO) Chart

And finally, MM holds the NB Global Income Trust (NBI), a very diverse portfolio of overseas ‘junk’ bonds, or in other words, higher risk, higher yield corporate debt. This is an area that has been under most pressure during March and remains below its previous high, although it did yield 5.8% over the past 12 months.

There has been central bank support for corporate bonds in the US, however this has been limited to investment grade credit or bonds that were investment grade prior to March. While that policy has provided some support for NBI, it’s still trading below its $2 issue price and at an 8% discount to its asset backing of $1.95

MM remains positive on NBI although this is higher risk exposure.

NB Global Income Trust (NBI) Chart

To give some further context around what’s played out in the US Bond market, 2 charts below are interesting.

The iShares IBOXX Investment Grade Corporate Bond ETF is a basket of higher grade US Corporate debt. Watching bond markets is key and at the moment, all is calm on the Western front

iShares IBOXX Investment Grade Corporate Bond ETF (LQD US) Chart

Although the ETF that tracks higher yielding junk bonds in the US is not as strong which explains the performance of NBI

iShares High Yield Bond ETF (HYG US) Chart

What will it take for bank share prices to improve?

The bear case for the banks is an easy one to construct, there’s hardly any loan growth, net interest margins (NIM) will probably fall further, non-interest income is stagnant except for the volatility provided by treasury and markets, expense reductions are difficult to achieve and credit losses from the COVID-19 shut down are about to emerge. Credit deterioration adversely affects both profit and capital for the banks which has a flow on impact to dividends. Not a lot to get excited about however these are all known knowns, the market understands all these negatives and includes them in the share prices. The issue is how much each of these items will deteriorate and the answer to that is governed by how long the economic lockdown will be in Victoria and how long it will take for the state borders to open.

The share prices assume that each major bank will have approximately $3B p.a. in bad debts in perpetuity. While this is the forecast for FY20 and FY21, it’s a highly unlikely scenario forever.

For that reason, we maintain a more positive bias towards the banks but like many, we are still struggling to see a near term catalyst, perhaps the fact no one sees a path for recovery here is catalyst enough!

We remain frustrated holders of CBA & NAB

Commonwealth Bank (CBA) Chart

Conclusion (s)

Hybrids remain a solid source of income and we remain comfortable holders.

The MQGPD is expensive and we are considering switching that holding

We remain comfortable with our broader holdings of income securities

Have a great day!

James, Harry & the Market Matters Team


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