On Monday, the Australian iTraxx – our local proxy for credit spreads – reached a new post GFC low of 71 basis points. Simply, this measure represents an average additional margin that investors expect to be paid for investing in an investment grade bond issue.
Putting the low number into perspective, pre GFC, the iTraxx was consistently around 30 basis points, but blew out to 443 basis points at its peak.
At this point in the credit cycle, investors aren’t getting paid much for taking on additional risk as spreads have compressed across the risk spectrum.
It would be a good time to review your high yield holdings – what is the percentage allocation in your portfolio? What would happen in the case of a market correction? Are happy with the returns you are earning?
While some investors have been boosting returns by taking on greater allocations to high yield bonds, we think this may be the time to do exactly the opposite and increase your exposure to investment grade and perhaps even government bonds. During the GFC high yield ‘got smashed’, prices declined dramatically and liquidity evaporated.
Investment grade yields won’t be as attractive, but you’ll be improving the quality of your portfolio and overall capital preservation.
For a more detailed explanation of the iTraxx, please see the end of this note.
Where we see value
There are still a number of investment grade alternatives that we think remain good relative value:
1. Residential Mortgage Backed Securities (RMBS). There are many inherent protections in these securities, such as: the structure providing subordination – assuming you don’t invest at the equity level, lenders mortgage insurance, seasoning for older RMBS issues, loan to valuation ratios and that ultimately, the borrowers are responsible for the debt.
There’s quite a lot of education regarding RMBS see the link at the end of this note, which also includes a webinar for existing FIIG clients. If you haven’t yet invested in this asset class, we highly recommend it. We periodically get access to various RMBS tranches but they are rarely discussed as existing clients are ready buyers.
Investors can expect investment grade securities with returns of around 4 to 5% per annum and even higher for lower rated, but hard to find BBB paper, depending on the specific tranche, amongst other factors.
2. Government bonds, especially Commonwealth government bonds are ‘zero risk’ investments and where investors head in risk off markets. During the GFC, prices of these bonds rose as investors exited higher risk investments.
3. Investment grade inflation linked bonds. These bonds have been overlooked given low inflation rates. But high fixed margins and investment grade credit quality make them attractive despite the inflation outlook. Sydney Airport 2030 capital indexed bond pays around CPI +3%pa
4. Switch out of subordinated debt into other investment grade securities, we agree with Chris Joye in his recent Australian Financial Review article that the asset class has been oversold. A good example is the recent AMP subordinated debt issue. Three times oversubscribed and printed at the low end of 180 basis points over the 3 month BBSW, had investors accepting 3.5%pa floating rate for the next five years.
5. Short dated high yield. Generally company balance sheets are in pretty good condition with many borrowing at low rates, meaning there’s a lower risk of imminent default and a very good chance you’ll be repaid in the short term.
The iTraxx
The Aussie iTraxx is a proxy for credit spreads in the Australian market. It is an index, not unlike the ASX All Ordinaries Index for equities, which provides information on the direction and trend of the market.
The Aussie iTraxx is composed of five year credit default swaps (CDS) for the 25 most liquid and highly traded investment grade Australian entities in the market.
Each of the 25 entities is given equal weighting and must meet the following requirements to be included:
- The entity has to be listed on the Australian Stock Exchange (ASX) and have a five year CDS
- All entities must be investment grade by any of the three major rating agencies (S&P, Moody’s and Fitch) that rate them
- Market makers submit a list of the most liquid traded entities for the previous 12 months to the International Index Company (IIC). IIC then computes final liquidity ranking for each entity. The entities making the iTraxx are the top 25 as per the IIC final list. The list is refreshed every six months
- All constituents have equal weighting of no more than 4%
- No more than five banks can be included in the Index, thus comprising no more than 20% of the total weighting
The “price” of the iTraxx is simply the weighted average basis point (bps) cost of the 25 CDS contracts with each individual CDS acting as a proxy for credit spread on that particular company.
