The news over the past week continues to be dominated by macroeconomic headlines and debate over the current effectiveness of the RBA’s monetary policy stance. Bond and hybrid investors have focussed on factors such as the first major bond default by a chinese property developer and hedge funds are circling Atlas Iron through a debt restructuring process. But before we dive into these factors we thought it was worth taking a step back from the news and look at the performance of equities and bonds over the last few years.
Equities v Bonds
This week we have reviewed two of the major Australian indices across equities and bonds and found that the performance between the two has been comparable over 12 months and 5 years . This may surprise many investors. Bonds are generally not as newsworthy as equities, so you dont hear about their performance in mainstream media. Equities (as defined by the ASX 200) have returned on average 8.15% per annum over the last 5 years and bonds (as defined by the S&P/ASX Australian Fixed Interest Index) 7.85% over the same period (20 April 2010 – 20 April 2015).
The drivers of performance for these indices is vastly different as one is earnings per share (EPS) orientated and the other is duration (interest rate sensitive) . If we look at them from a technical perspective (especially in the last 12 months) the main driver of performance has been one theme. That is a ‘lower risk free rate’ (i.e the10 year government bond rate ). Over the past year we have seen the yield on the risk free rate drop from 4.0% to as low as 2.28%. So how does this relate to performance:
- If bond yields drop prices on bonds go up (Price = Duration x Yield)
- All discounted cash flow models (capital asset pricing models) use the risk free rate when assessing the cost of capital. As the risk free rate is lowered the value of the same cashflows increases and so to will the price of the equity.
This is by no means the complete story when it comes to performance across asset classes, nor does it mean that the future will in any way resemble the past. What it is does say is that equities are not the only solution . Interest rate markets can provide you with stable long term returns which meet investor requirements and may be just as good as equity marketsl. The key difference is timing your entry and exit across these asset classes – equities being the more volatile asset class.
In other news, Atlas Iron is looking like the first casualty of the iron ore price collapse and the company debt looks like it will play a significant role in the restructure. It is our opinion that the iron ore market needs significant supply cuts to elevate the iron ore price in order to save the small-mid cap iron ore miners and their contractors. There is no doubt some of the supply to the seaborne market has been removed but it still needs a further reduction . The rating agencies have all jumped on the failure of Atlas Iron and downgraded its credit rating, which is a bit late for investors. What is interesting is the restructure has caused current lenders (quasi bond investors) to push for Atlas to enter voluntary administration so they can carry out a debt-to-equity conversion. It is understood more than half of the miner’s $US275 million Term B Loan holders have sent a letter to the company suggesting it is insolvent and has defaulted on its loan. This is primarily because Atlas will run out of funds within the year and result in closure of its mines which constitutes an event of default under the terms of the loan. This will no doubt end in a lot of negotiation between shareholders and creditors but it does have a precedent. In 2012 Mirabela Nickel shares were compulsorily transferred from shareholders to creditors without the shareholders’ consent. The Supreme Court of New South Wales approved the debt-for-equity restructure, through which bondholders exchanged $US395 of notes for a 98.2 per cent stake in the company. What does this mean to retail investors? Nothing, but is does show how quickly a company can go from having a market capitalisation in the billions of dollars to quickly defaulting on its loans. It is very important that investors understand the drivers that can cause a default – 9 times out of 10 it is cashflow related.
In an important (but not directly relevant to domestic fixed income investors) bit of news outside Australia, Kaisa Group Holdings Ltd. became China’s first real estate company to default on its debt. The company defaulted after failing to pay the interest on two US dollar bonds (even after it was given a grace period). While we clearly do not cover the Chinese developer,the default has caused problems across asia’s debt markets with high yield debt repricing across multiple issuers. It is our understanding that holders of the US dollar bonds will recover just 2.4% in a liquidation. While this does not have a direct impact on Australian bonds, the global market is all relative and if we start to see a series of defaults in the chinese market there is no doubt that market volatiltity associated with the price confidence will flow through to other markets including our own.
Finally to macroeconomic news. last week the ABS released inflation figures for the first quarter of 2015. These figures show that inflation continued to ease in the March quarter, driven predominantly by lower oil prices. The headline figure is now at its lowest point in three years but investors should pay more attention to the core measures, which is what the RBA does when analysing data for monetary policy decisons. The data is a little confusing as the headline data and core data are really telling two different stories. Consumer prices rose by 0.3% in the March quarter (which was inline with market expectations) but core inflation (which removes volatile items) actually exceeded market expectations rising by 0.6%. The important point here is that the headline annualised inflation rate is well below the RBA’s medium-term target for annual inflation of 2 – 3 %. Normally you would expect the RBA to cut rates but they look at forward looking drivers of inflation, not historical. We have now had solid employment and inflation figures for the first quarter of 2015 which is why the RBA has kept rates on hold and to see if the trend continues. The minutes from the last meeting provided a clear indication that the RBA would likely cut rates further but the inflation data says otherwise.
Confused? The market is too. You can see in the chart below that the probability of a rate cut at the next RBA meeting has fallen to only 55%. This tells us that that the market is confused about the timing of the rate cut. There is no doubt the market expects further rate cuts, but the question is when?