Income Report / Income Report; Are corporate bonds becoming too risky?

By Market Matters 23 January 19

Income Report; Are corporate bonds becoming too risky?

Market Matters Income Report 23rd December 2018

The ASX opened lower this morning however some better than expected employment figures out at 11am showing skilled vacancies were higher than expected, prompted a recovery – mainly led by the banks which has been supportive of the overall index.

The ASX 200 trading down just -9pts at 5848 which is a reasonable effort given the US market was down ~300pts, although we had foreshadowed some of the decline yesterday. Challenger Group Financial (ASX:CGF) has downgraded earnings expectations and are trading down ~13% while Gold miner Northern Star (ASX:NST) is off around 9% following a weaker than expected December quarter production update.

Over the past week, the Income Portfolio added +0.95% while in the current financial year to date, it is down -0.45% vs the benchmark (RBA + 4%) of 3.09% while the ASX 200 accumulation (including dividends) is down by -3.33%. The last week saw Super Retail Group (SUL) and Suncorp (SUN) do well – we sold Suncorp yesterday and plan to cut Super Retail (ASX:SUL) from the portfolio today   **watch for alerts**

Are corporate bonds becoming  too risky?

Last week we penned a note on the US corporate bond market and asked the question whether or not it was a concern for stocks, which it is, as are a lot of other things. This prompted a number of questions about bond exposures in the MM Income Portfolio which we’ll cover today.

The only direct exposure to US Bonds we have is the holding in the NB Global Corporate Income Trust (ticker NBI.ASX), which commenced trading on the ASX in September of 2018. As a refresher, this is a US based asset manager called Neuberger Berman and they raised $413mil for a listed trust that invests in global corporate bonds – the area that we wrote about with a negative slant last week, hence why hold such a security?  It’s a good question.

This fund uses a currency hedged corporate bond strategy and they aim to pay 5.25% p.a. paying distributions monthly. It was obviously a new product when it launched however the underlying portfolio and strategy have been in existence for over 20 years, and they’d booked returns of 8.93% pa on average over that period – which is a strong track record over a long period of time.

Track records are essential when managing money however it’s by no means a guarantee of success – the most high profile example last year came from the guys over at L1 Capital (ASX:LSF) who listed last May to much fanfare, had an exceptional track record prior to listing, before losing ~27%  in 8 months! While these are completely different funds with different exposures and inherent risks, it still highlights how important it is to continually track investments, particularly in the current environment.

NBI publishes a daily NTA report (net tangible assets) which provides a good look through on the value of the underlying portfolio versus the price of the listed trust. We track this through Bloomberg and plot it on a chart, The blue line is the value of their holdings and the white line is the price of the security. The green shaded area at the bottom outlines the premium (or discount) the fund trades relative to its assets. Since listing, and bear in mind it’s only a short period of time, the fund has averaged a 3.06% premium to its NTA while it has only once traded at a discount to NTA very briefly just a few weeks ago. Currently, NTA sits at $1.97 while the fund closed yesterday at $2.02.

NBI, NTA versus price since listing

From the above, we can see that the end of December was weak and NTA dropped by 5% to a low of $1.90. The price of the trust held up better however it’s a red flag to look at what drove the decline in NTA. The other obvious trend has been the slight / gradual decline in NTA between September and December. The Fund pays monthly distributions targeting 5.25% pa. To date, they’ve paid 3 totalling 2.64c, or on an annualised basis, they’ll get to the 5.25% targeted income. 

Firstly, what drove the decline in December? Pretty much the theme we discussed in a morning note last week (click here to view), which was the increase in spreads between lower quality US bonds and risk free US Treasuries, or in other words, the premium that investors demand to take on additional risk. In that report, we were looking through the lens of an equity investor saying that increased spreads made borrowing money more expensive for US corporates and that could reduce the amount of capital available for company buy-backs.

We said at the time, the below chart shows the trend is slowly moving against stocks but it’s still fairly cheap for corporate America to borrow money – identifying where the uncle point is obviously the million dollar question.

US BBB/Baa Corporate bond – US Treasuries spread Chart

That chart shows the move in corporate spreads nicely from September (when NBI listed) to December with a clear widening of spreads during that time. The environment has clearly gotten tougher, and the push up in spreads during the December quarter would explain the decline in marked to market asset values that flow into the NTA of the fund.

The chart above though is a relatively short time frame. Investing in bonds is a defensive position and looking longer term is more important. The below chart looks at spreads back to 2004 and incorporates the GFC to put the recent move into context. While spreads have increased, the current move is a ‘slight elevation’ rather than a blowout. If a slight elevation led to a decline in NTA of 5%, that suggests a bigger widening would impact NTA by more, and therefore the pricing of the listed trust. In short, if credit markets get more volatile, then the NBI will likely struggle.

US BBB/Baa Corporate bond – US Treasuries spread Chart – longer dated

The other trend though that we’re conscious of has been the gradual decline in NTA since listing. This is probably more important from an overall perspective. While I haven’t spoken to the investment managers since listing, and it’s only early days, it seems like the fund may be using more than just regular coupon payments to support the monthly distribution which is creating a negative trend on the NTA. i.e. they’re dipping into capital to maintain consistent distributions.  That could be a short term theme given it’s only just been listed / portfolio set, and it’s not uncommon in the listed fund space as a way of smoothing distributions (Geoff Wilson at WAM has done this for a long time),  however I’ll endeavour to find out from the managers and report back. (As an aside, for those interested in our view of WAM, we covered it towards the end of last year – click here)  

When we added NBI to the income portfolio we wrote… With huge diversification across the portfolio, they hold around 300 individual holdings with position sizes between 0.25% – 0.50% of the portfolio. Normally we like to hold assets directly, however simply put, we can’t get the level of diversification or access to these sort of investments outside a fund structure such as this one. We like NBI for an income play, and so too does the market with the trust currently trading 2.5% higher to $2.05 today, above their NAV at listing of $2

That diversification reduces company specific risk, however it does mean they’re more or less exposed to what the broader corporate bond market does – something we’ll continue to monitor. For now, we’ll retain the holding but watching US bond spreads carefully.  

NB Global Corporate Income Trust (ASX: NBI)

Conclusion (s)

A widening in spreads is a negative for the price of bonds and therefore the price of NBI
However, we’ve only seen a slight uptick so we’re alert, but not alarmed at this stage.
We are cutting SUL from the Income Portfolio for a loss

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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