Income Report / Income Report: Why we’re not concerned about Hybrids

By Market Matters 11 March 20

Income Report: Why we’re not concerned about Hybrids

Market Matters Income Report 11th March 2020

The ASX recovered strongly from lows yesterday while today its giving back some of those gains, typical choppy trading action after such a savage sell-off. Interestingly, the ASX 200 touched the bottom of its trading channel as shown below and rejected it aggressively. While at MM we wouldn’t be surprised to see a re-rest of the lows, we’re expecting further upside in the near term before that happens.

Overall, the ASX 200 is currently trading down -90points / -1.53% at 5842.

ASX 200 Chart

The Income Portfolio had negative performance during the week of -6.34%, however, as has been the case throughout the meltdown, it outperformed the ASX200 Accumulation Index which traded down more than 11%. The bulk of positions fell, with the ActiveX AROB the only gainer. The worst two holdings were Woodside (WPL) which fell 21% and Perpetual (PPT) which fell 17%. Perpetual also paid a dividend during the week, alongside BHP and RIO while three of the hybrids paid distributions – AMPPB, CBAPG & NABPF. Performance fell into the red for the current financial year, down 4.92% versus its absolute return benchmark of +3.35%. Since inception, the portfolio is up +9.3% vs the benchmark of +14.27%.

Why we’re not concerned about Hybrids

Hybrid securities have been sold down on the ASX as market volatility increased over the past few weeks. The Hybrid Index, known as the Solactive Hybrid Index Grossed for distributions has declined by ~4.50%, causing some concern for holders, however we think this is overblown, simply a consequence of broader market pressures rather than something untoward in the space.  

Solactive Hybrid Index (gross) chart

Why the decline?

A few reasons, however the main one being a widening of credit spreads globally. When we talk credit spreads we mean the additional premium required by the market to take on corporate credit risk over and above safe government bonds. Putting it a simpler way, if I can get 1.5% in a term deposit, what ‘margin’ above that do I require to take on more risk? Naturally, these spreads are impacted by how comfortable / uncomfortable the market feels about things. With a 20%+ drop in equities, clearly the market has panicked and that filters through into other areas to varying degrees, the hybrid market being an example.

While hybrids are not bonds, the below looks at movements in spreads, which is relevant to hybrid pricing. Clearly they have moved higher, but not materially so. 

Credit Spreads Chart

Also amplifying the move in listed securities is liquidity. We often site liquidity as a positive, and that’s true, however liquidity also creates short term movements that are not aligned with fundamentals. Margins calls happened yesterday morning and selling a hybrid or two to fund a margin call on equities makes sense for some. Hybrids were sold hard early, before recovering strongly which talks to this influence.

Is it a concern? 

Not yet, but like everything we need to keep a close handle on it, its also very relevant for equities. The chart below looks at the hybrid index versus the ASX total return index over time, the hybrid market has returned around ~6.4%pa with annualised volatility of around 3%, whereas the rule of thumb in equities is a 10% annual return with 10% annualised volatility. When looking at return per unit of risk, hybrids are superior.

Hybrids (white) v Equities (Orange)

Do we like hybrids?

Investing is all about assessing risk v reward and right now, that matrix says to buy hybrids. Since the GFC we’ve seen a wave of bank regulation hit the sector and rightly so. This has been a clear negative for bank shares but a clear positive for bank debt including hybrids which sit in the middle (they can convert to equity under extreme circumstances).

As an example, CBA’s equity ratio on their balance sheet in 2007 was around 5%, meaning that it was levered 20x, today that equity ratio sits around above 10% meaning that it is currently levered less than 10x. Lending criteria has tightened significantly, they’ve simplified their business as much as possible and now sit in a very conservative place - they are now lower risk, lower return vehicles.  

From an equity perspective, return on equity has been falling as a consequence of this de-risking, however that has improved the risk / return dynamic in hybrids.

MM believes the current sell off is overblown, and we remain comfortable with hybrids.

CBAPF Chart

Top 10 most actively Traded Hybrids yesterday

Source: Shaw and Partners

What else is catching our eye in the income space?

Listed Income Trusts (LIT’s) that invest in credit strategies are garnering a lot of attention, mostly negative. We hold 2 in the portfolio, one from Metrics (MXT) which is a credit fund and one from Neuberger Berman (NBI) which is an international bond fund. We’ve also discussed many others over the past year or so, giving the rest a wide berth

Neuberger Berman (NBI) $1.80: Invests in high yield bonds globally with the portfolio typically holding between 250-300 bonds. Its split roughly between 60% in the US, 20% in Europe and 20% in emerging markets. NBI has an issue price of $2.00, so trading $1.80 is weak. The sell-off is a result of concerns around high yield debt markets, mostly on the back of a plummeting Oil price. NBI release NTA on a daily basis, and yesterday’s NTA was $1.91. A good chart to monitor with regard to demand for high yield credit is the iShares High Yield Bond ETF (below), this was sold hard however has also bounced back strongly. As a company, NBI manage around $355bn across their book and while this is a high yield strategy, so higher up the risk spectrum in terms of fixed income exposure, we remain comfortable holders on a risk / reward basis.

MCP Master Income Trust (MXT) $1.96: Invests in corporate loans and are good at it. NTA currently sits at $2.0036 and is reported daily. They recently raised $344m through an entitlement offer at $2.00 per unit. We remain comfortable holders.

iShares High Yield Bond ETF

MCP Master Income Trust (MXT) Chart

We wrote about the broader income security space a few months ago (click here) while we also covered the KKR listed Trust last week (click here)

Conclusion (s)

Credit markets have moved further over the past week, with spreads widening.

We are positive tier 1 bank hybrids into recent selling.

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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