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GE & AMP: Case Studies in Tactical Investing

In April this year, the Banking Royal Commission prompted the first large company scalp with the resignation of AMP’s (ASX: AMP) CEO Craig Meller.  Mr Meller’s resignation followed revelations of serious misconduct by the institution for almost a decade and capped off a week in which its failures were brutally and publicly exposed.

A few months later in the USA and (mostly) unrelated, General Electric’s (NYSE: GE) credit rating was downgraded from A to BBB+ on 2 October 2018 – the day after the debt-riddled conglomerate simultaneously dumped its CEO and announced that it would yet again fail to meet earnings and free cash flow expectations.

As seen in Figure 1 below, equity markets responded quite naturally to the chaos in both instances with AMP’s stock price plummeting in the two weeks following its appearance at the Commission as investors appropriately priced in the possibility of future penalties and adverse consequences of the institution’s cultural and managerial failures.

Figure 1. Historical Stock Prices of General Electric and AMP

Source: BondAdviser, Bloomberg

The response in debt markets, however, and, specifically the downward price pressure (widening spreads) on short-tenor instruments, highlighted a common tendency for debt markets to exaggerate the impact of such events on short-term credit risk.  The inclination for spreads on these instruments to widen significantly despite minimal short-term changes in risks creates ample opportunities for credit investors to exploit market mispricing.

As mentioned, the weeks of scrutinising AMP culminated on 20 April 2018 with the resignation of its CEO.  Figure 2 below shows the spread widening witnessed on two AMP Limited Tier 2 instruments, being the AMP Subordinated Notes 2 (ASX: AMPHA) with a then-tenor of 0.67 years, and AMP Wholesale Subordinated Notes 2 (ISIN: AU3FN0037917) with a then-tenor of 4.62 years.  Despite the former having just 8 months to maturity and the Royal Commission concluding in February 2019 (3 months after maturity), spreads actually widened much more on the shorter-dated AMPHAs when compared to the Wholesale Subordinated Notes 2.

Figure 2. AMPHA and AMP Wholesale Subordinated Notes 2 Trading Margins

Source: BondAdviser, Bloomberg

Credit risk is, of course, inherent in all debt securities and essentially represents the issuer’s risk of default.  The revelations uncovered during the hearings and their potential consequences – namely the possibility of future penalties and the long-term consequences of the serious cultural, operational, and managerial failings – posed a credible threat to holders of longer-term AMP debt.  These factors, the market rightly determined, were sufficient to widen the credit spread on AMP’s Wholesale Subordinated Notes 2, which rose from 1.69% to 1.78% over the month, as seen in Figure 2 above.

Figure 3. GE Trading Margin Comparison

Source: BondAdviser, Bloomberg

Similarly, when GE’s credit rating was downgraded on 2 October 2018, in the wake of its high debt, poor operational and managerial performance, the widening of the credit spread for its longer-term, GE 6.15% 2037 instrument, was expected and for the most part, appropriate.

The widening of the shorter-term AMPHA and GE 6.00% 2019 margins, however, occurred despite the relatively minimal impact the events and their consequences could ever practically have on AMP’s and GE’s respective credit risk in the short term.

At the time AMP first fronted the commission, it was in a healthy position financially and in the eyes of the market posed little risk of default in a mere 8 months (when AMPHA was expected to mature).  Although the Commission hearings were damaging for the institution’s reputation and moderately so for its credit risk in the long-term, the risk of default for its short-term debt remained largely unchanged.  Similarly, the downgrading of GE’s credit rating, although significant for the holders of longer-term debt, should have had a relatively smaller impact on the credit risk of its shorter-term instrument.

The credit spread widening of both these instruments, therefore, relative to their longer-dated counterparts, in our view, represented clear market mispricing and created a tactical investment opportunity to buy cheap, short-dated instruments where the impact of the changes should never be felt.

The tendency for markets to overweight the significance of events of this nature creates many opportunities for astute investors to exploit market mispricing and pick up a tidy profit in the process, just as we did for our own portfolios.