Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 348

5 lessons from the GFC as panic whips hybrids

The last fortnight has caused carnage on global markets. The S&P/ASX 200 dropped close to 20% in less than 10 days and the benchmark Australian iTraxx index (a proxy for Australian investment grade credit spreads) blew out from just 46 points on 20 February 2020 to 110 points on 9 March 2020, as shown below:

Source: Bloomberg

The circumstances evoke memories of the GFC. There were some important lessons that can be learnt from that experience for fixed income investors.

Unlike equities, the terminal value of a bond is largely a known quantity. The vast majority of bonds are issued at $100 (or par value) and they mature at $100. The value fluctuates between issue date and maturity date but the key point is that unless the company fails, bond holders will get $100 on maturity.

Five rules of thumb for assessing bonds

Failure or default is the key risk that investors need to assess but even in the most difficult economic times, the default rate of high quality, investment grade bonds is rare. However, the default risk increases significantly for sub-investment grade or high yield bonds. This makes assessing bond value far easier than valuing equities in times of severe market dislocation such as the past week.

Following the blueprint from past crises and in particular the GFC, there are a number of simple ‘rules of thumb’:

  • Assess the probability of the company or issuer defaulting. If you think default is highly unlikely then all you need to assess value is the yield to expected maturity. In other words, if the company survives, you will be able to determine the expected yield to maturity, as the ‘terminal’ or maturity value will be $100 or par.

  • Be patient but also be ready to act at very short notice. Short notice means as little as a few hours. Many of the best opportunities in the GFC came with very little notice and investors were rewarded handsomely for simply providing liquidity.

    Single-A rated Tier 1 Hybrids from the likes of Rabobank, CBA, SwissRe, NAB and AXA all traded at less than 50c/$ in 2009 when large funds had to liquidate holdings at short notice or overnight. These highly-rated securities provided returns of circa 20-25% p.a. for a number of years for those who invested at prices below 50c/$.

    Even in today’s market panic, ASX listed hybrids ANZPE, NABPD and WBCPF traded at margins over +850bps for those ready to act quickly but closed closer to +500bps. The best time to buy is when there is a forced seller (typically a fund or institution) in the market who just needs to find a buyer. If you are comfortable that the company will survive to maturity date, it is a question of what price to pay because it could go lower.
  • Stick to large, high quality issues. Focus on investment grade companies that are large and have good access to equity and debt funding. We call these companies 'best of breed'. The probability of investment grade bonds defaulting is significantly less than high yield bonds. As the chart below of historical probability of default by credit rating demonstrates, credit risk past BBB- (i.e. sub-investment grade) is exponential. The price volatility of investment grade bonds versus high yield is also significantly lower. A number of oil and gas sub-investment grade bonds in the USA are down 20-30% this week alone, whereas names like BP and ExxonMobile have only fallen 2-3%.

Source: Standard and Poor’s Historical Default Rates

  • Be prepared to move down the capital structure or take call risk on subordinated bonds and Tier 1/Additional Tier 1 hybrids from best of breed companies. As detailed above, many of the best returns after the GFC were Tier 1 hybrids from SwissRe, AXA, RaboBank and NAB. But also consider re-set margins. The higher the re-set margin, the higher the probability of call at first opportunity.

  • Watch out for companies that have a large refinance due. In a crisis it can be very difficult and often impossible for companies to raise new debt (typically required to refinance debt coming due). Companies that have spread their debt maturity profile and even companies that are just unlucky enough to have a large refinance right in the middle of a crisis can quickly become stressed or even default. This risk is magnified as you move down the credit or rating spectrum and is typically the cause of high yield bond defaults. Companies that run a high level of cash on balance sheet are highly sought after. In a crisis, cash is king.

Opportunities in bank hybrids

The bank hybrid market is worth keeping a close eye on. Given the inefficiencies and relatively illiquidity in this market this is presenting some outstanding opportunities. Today, we have seen our favourite security in the hybrid market – the National Income Securities (NABHA) – trade as low as $85 providing a yield to expected call in excess of 10.0%. However, it recovered and closed unchanged at $92. NABPD had a range of almost $10 over the day.

We are not sure how long these opportunities will last and acknowledge that investors essentially need to be ‘watching the screens’ to take advantage. We prefer those with initial credit margins over 450bp (4.5%).

We have often written our simple rule of thumb for ASX listed hybrids are they are expensive at credit spreads under 300bps but attractive when approaching 500bps. Earlier today, the average major bank 5-year credit spread was well over 500bps and possibly 600bps. Just a month ago, that measure was just under 300bps, demonstrating how quickly the market can change.

A comment on the mining and energy sector

A number of debt securities in the mining and energy space have been caught up in the market sell-off, especially those that are non-investment grade. We remain wary of many of the companies in this sector particularly those with high debt loads given the potential for a phase of significantly lower commodity prices in the event that the world slips into a global recession which is becoming an increasingly likely proposition.

 

Justin McCarthy is Head of Research, and Brad Newcombe is a fixed income analyst at BGC Fixed Income Solutions, a division of BGC Brokers, and a sponsor of Firslinks. The views expressed herein are the personal views of the authors and not the views of the BGC Group. This article does not consider the circumstances of any individual investor.

For more articles from BGC, click here.

 

RELATED ARTICLES

Do bonds still offer a buffer to equity volatility?

It's like opening your best champagne at 5am

'Unprecedented' should be 'here we go again'

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.