Income Report / Income Report; Yield Curve – what it is & what it can mean, BHP Buy Back

By Market Matters 05 December 18

Income Report; Yield Curve – what it is & what it can mean, BHP Buy Back

Market Matters Income Report 5th December 2018

The ASX has opened sharply lower this morning following a very weak session overseas – financial stocks are feeling the brunt today, largely a result of softer expectations around US interest rates, a topic we’ll discuss below along with the BHP share buy-back.  At time of writing (10.49am), the market is trading down -83 points at 5630, however that is more than 20 points up from the session lows. Despite the weakness this morning, we remain bullish into the end of 2019.

ASX 200 Chart

For the week, the MM Income portfolio added +0.45% against a backdrop of the ASX which fell by -0.26%. For the financial year to date, the portfolio is down -0.88%  versus its benchmark of RBA cash rate +4% which sits at +2.35%  while the ASX 200 accumulation (including dividends) is down by -5.95%. No major movers in the portfolio this week.

Yield Curve – you’ll start to hear a lot about this!

As we suggested this morning, the US yield curve produced its first inversion on Monday night with the 2 – 5-year bond yield gap turning negative for the first time in over a decade.  Here’s what it can mean:

The direction of interest rates is generally indicative of the health or otherwise of an economy. Higher rates generally mean that the economy is doing well with growth and inflation moving higher. Lower interest rates imply weaker economic growth and softer inflation, an economy is not doing as well. Bonds are issued with varying durations from Governments (and corporates)  around the world, with the US being the most important. The US Government issues 2yr, 3yr, 5yr, 10yr & 30yr bonds and that allows traders / investors to play their view on future economic prospects and therefore interest rates. Looking at the relationship between bond yields with different maturities provides insight into the markets future expectations about an economy’s prospects – this relationship between yields and time frames is often referred to as the yield curve.

The yield curve typically slopes upward because investors want to be compensated with higher yields for assuming the added risk of investing in longer-term bonds. Keep in mind that rising bond yields reflect falling prices and vice versa. A flat yield curve indicates that little, if any, difference exists between short-term and long-term rates while there are rare occasions where the yield curve can become inverted, meaning that short term interest rates are higher than long term interest rates.  Inverted yield curves have occurred on only eight occasions since 1958 when considering  the 2 – 10 year spread.

Today there is a lot of talk circulating about  “inverted yield curves” and “recessions”. Its correct that the 2 – 5-year bond yield gap turned negative for the first time in over a decade however the gap between the 2 & 10-years is traditionally watched more carefully.  While this major signal has not been triggered it’s rapidly getting closer – and is providing another concern in a market that is clearly glass half full.

US 2 and 10-year Bond Yields Chart

In the last 24 hours, the moves in the US Bond markets have been fairly significant. We have written previously about the markets view on interest rate being too bullish, or in other words, the market was overplaying the likelihood of an interest rate hike in December 18, and importantly the pace of rate hikes during 2019. We are now seeing those expectations come back and the market is now only implying 0.29% of hikes in 2019.  The positive implication is that lower rates should support asset prices if earnings don’t deteriorate.  

US 10-year bond yield

 

The yield curve has been flattening in recent times implying a more negative outlook for US growth (and therefore future rate hikes). The short-end of the yield curve (shorter dated bonds) which is the end more exposed to the near-term actions of the Fed,  has held up well however the middle-to-end of the curve which is more heavily influenced by markets / traders’ expectations about future growth and inflation has taken a hit.

An inverted yield curve has led a US recession 100% of the time, or in other words, ahead of every US recession short term bond yields trade at a higher yield  relative to longer term bond yields, however a recession has not followed an inversion in the yield curve 100% of the time  (i.e.  every chicken produces an egg but not every egg produces a chicken).  That all  makes fundamental sense - if the market believes that the economy will get worse then the Fed may need to cut interest rates to support growth hence we see lower long term rates relative to shorter term rates.

While it’s true that a recession is often led by an inverted yield curve, there is a lag between when that happens and when a recession starts as shown in the Bloomberg graphic below.

 

And looking at the S&P 500 relative to the yield curve is also less alarming than can often be portrayed. Generally stocks continue to rise after yield curve inversion.

It’s clearly easy to link yield curve inversion with recession and then just as easy to link recession with the GFC, however a recession does not typically occur for another 12-18 months after an inversion in the yield curve, and we’re talking 2 - 10 years, which are yet to invert (although are close). The drop in interest rate expectations in recent days should actually be a positive for asset prices if the economy does not falter. Apart from changing expectations around rates, we’re not seeing any meaningful stress economically at this point.   

BHP off market Buy Back – a good deal for some

BHP Billiton (ASX: BHP) has followed RIO Tinto (ASX: RIO) in announcing an off market buy-back of their shares as part of a wider capital management program following the sale of around $US10.5bn worth of assets in the U.S. As was the case with RIO, the structure will be attractive for those shareholders that pay no tax, or enjoy a low tax rate – something south of ~22%.

Here’s why. The deal is structured as a small capital amount ($0.38) and a large fully franked dividend ($26.81). The franking benefit for those in a zero or low tax environment creates the opportunity. While the pricing of the deal is currently playing pout (with the pricing window closing on the 14th December), the deal looks a worthwhile one for holders of the stock that have a low tax environment.

In short, BHP has made an offer to buy back stock at a discount to the market price – somewhere between an 8% and 14% discount. Given recent history the 14% discount will likely play out. So, for explanation sake, based on yesterdays close of $31.62 BHP will offer to buy back shares at $27.19 – a poor deal on face value. However, the deal is structured with a small capital component ($0.38) and the balance being a fully franked dividend.

Subtracting the capital component of $0.38 from the assumed offer price of $27.19 ($31.62 minus 14%), we get a dividend amount of $26.81 fully franked. The gross value (after franking) of that dividend is therefore $38.30 ($26.81/0.7)  plus the $0.38 capital component giving a total value of $38.68 after tax for those currently enjoying a zero tax environment.

Breakdown up of BHPs off market buy back.

For those in a super fund paying 15% tax there is still a benefit of around 13% based on the assumed prices. The cut off seems to be around the 28% mark in terms of tax rate.

BHP tender price

The figures outlined above are based on an assumed purchase price of $33.11 for BHP shares on the 1st November 2018, the last day shares traded cum buy-back . A different purchase price will impact the after tax outcome. Subscribers should consult their tax agent to determine the actual benefit of tendering shares into the buy-back.   

Clearly this is a good deal for some. Because of that, the discount will probably be 14% and the deal will likely be substantially oversubscribed – or at least that’s been our experience with these sort of things in the past where we tender shares, take market risk on our stock only to see the allocations be so low that we simply lose 10-20% of the shares tendered and keep the rest. However, in this case, the BHP buy-back is a big one, bigger than RIO recently and bigger some  

BHP (ASX: BHP) Chart

Important Dates

·         Shares can be acquired up until the 1st November 2018

·         Shares must be owned on the 5th November 2018

·         Buy back tender period opens on the 19th November

·         Buy back tender period closes 14th December (tenders must be received by 5pm AEDT)

·         Announcement of buy-back price and any scale back 17th December

·         Shareholders receive proceeds 24th December

·         There is also a planned special dividend in January with BHP trading ex-dividend on 10th January 2019 (meaning shares can be bought up to and including the 9th)

Conclusion (s)

An inverted yield curve is a negative sign, although we’re not there yet when looking at the 2 – 10 year spread

The BHP Buy-back makes sense for some, depending on tax position

Have a great day!

James & 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.

Disclaimer

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 05/12/2018

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