NEWS + VIEWS – 04/10/2024
MARKETS
US markets continued their push upward following the Federal Reserve’s 0.5% interest rate cut. Fed Chair Jerome Powell has expressed his confidence that the economy will continue to grow but at the same time, claims that he is in no hurry to make further rate cuts. Investors are weighing positive economic data against the prospect of escalating conflict in the Middle East.
Domestically, share markets have been following the US path. Local bond markets are betting that the Reserve Bank (RBA) will cut interest rates this calendar year, even as Chair Michelle Bullock insists that they will not be cut in the near future. The RBA is hesitant as employment has been quite resilient although this is coming from record government spending. At some stage that is likely to turn.
HOW ARE THE US AND CHINESE ECONOMIES TRACKING?
The US has the largest economy globally and China the second largest but with the greatest influence on our economy.
The bigger than expected 0.5% rate cut by the Fed raised concerns in investors’ minds that the size of the cut may be in response to a weaker economy. The US Conference Board tracks leading economic indicators (LEI) to determine whether the US economy is approaching or in recession. The chart below shows that the risks of a US recession have receded, which is good news for investors globally.
‘The six-month growth rate of the LEI has trended less negative, switching off the recession signal’
However, China is a key concern, particularly for Australian investors as our economic fortunes are so closely tied to China. In this case, the Conference Board’s readings are less optimistic (see chart below).
‘The widespread weaknesses among China LEI’s components continued to suggest headwinds ahead and kept the warning signal on’
The chart illustrates why China’s leaders released a raft of stimuli. These are ‘early days’ in terms of their impact on the economy and still may struggle to impact the struggling property sector.
Domestic share markets reacted in the past week to the announced Chinese measures with miners’ share prices jumping. At the same time, money is rotating out of banks that have had a stellar run.
ALTERNATIVES TO BANK HYBRIDS
In the last edition of the News and Views, we discussed APRA’s proposal to wind back bank hybrids by 2032. Bank hybrids are likely to be around for a while yet, but it is unclear whether banks will continue issuing new hybrids to replace maturing ones. Both the Commonwealth Bank (CBA) and ANZ have hybrids that are due to mature in the first half of next calendar year, so there will be more clarity then.
The banks have an interest in continuing to issue new hybrids as they can attach franking credits to the interest paid on them. Using franking credits to bolster hybrid returns means that they are a relatively cheap form of capital for the banks. The alternative for banks to utilise franking credits is to either pay higher dividends or special ones. Neither would be as attractive as a hybrid issue.
Many of our clients hold bank hybrids so we have been doing some work on possible alternatives. During the week, we met with Betashares, the issuer of the Active Australian Hybrids Fund (HBRD) and the Australian Major Bank Hybrids Index ETF (BHYB), to get their take on the bond market and some further detail on other Exchange Traded Funds.
Hybrids less risky?
Betashares’ fixed income team is of the view that the recent rise of hybrid prices reflects APRA’s view that the government would not allow hybrid holders (in particular retail holders) to be ‘bailed in’ in the event of a bank becoming distressed. This is contrary to hybrid terms and conditions that allow (or force) hybrids to be converted to shares if Tier 1 capital falls below a specified level.
If hybrids are unlikely to be converted, then the hybrids are in fact less risky than previously thought and more in line (risk wise) with Tier 2 capital. Consequently, hybrid prices have been rising to reflect this ‘reduced’ risk. In turn, yields have fallen resulting in lower returns. Note that this does not affect investors if the hybrids are held to maturity.
Australian Major Bank Subordinated Debt ETF (BSUB)
One product we reviewed with Betashares was BSUB, which invests in major bank Tier 2, floating rate, subordinated bonds. Subordinated debt holders are paid before shareholder and hybrids holders, but after depositors and other senior debt holders.
BSUB tracks the index of major bank subordinated debt and currently yields around 5.6% p.a. While this is below the yield to maturity of some longer dated hybrids, it attracts a lower theoretical risk. Rated A-, the ETF implies a very acceptable investment risk, which one would expect given the exposure to the four major banks. Betashares aims to cover their management fee of 0.29% p.a. by the timing of their trading.
Compared with the current 12-month term deposit rate of 4.70% from Macquarie, BSUB is delivering around 0.9% above this level. This may become more difficult as interest rates fall but one should expect to achieve a reasonable margin above term deposit rates.
BSUB is just one interest bearing product that we have been researching as an alternative to hybrids. There are a number of securities from other fund managers that we are considering.
Gerard O’Shaughnessy
P 0423 771 330
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