Originally published by Narrow Road Capital
Risk asset returns were scattered in August showing no consistent theme. Chinese (2.3%) and US equities (0.1%) rose, but Australian (-0.1%), European (-0.8%) and Japanese (-1.4%) equities fell back. Investment grade credit was flat in the US, but global high yield saw some selling as investors reflected on the limited upside/material downside outlook. Commodities were also mixed with US natural gas (7.8%), copper (7.5%), iron ore (7.1%) and gold (4.1%) all rising strongly. US oil (-6.2%) was the standout loser with Hurricane Harvey partly to blame.
The credit cycle graphic below is a helpful way of thinking about the different stages of the credit cycle. Whilst the analogy with a clock isn’t perfect (credit cycles can move counter-clockwise at times) it illustrates the phases that investors typically move through over the life of an economic and credit cycle.
In the US, Europe and Asia the clock is currently at around 11. Whilst credit is not at the completely insane levels seen in 2006 and 2007, low margins and issuer friendly structures abound. Excesses can be seen in global high yield debt, US auto loans, developed market sovereign debt, emerging market debt (both corporate and sovereign), and household debt in Canada and Australia. The misuse of debt in China stretches across corporate, government and consumer credit.
Within that global picture there remains some pockets of value. Private debt is rapidly becoming a more competitive sector but there is still a varying level of liquidity premium available for patient investors. Those willing to invest in smaller (typically
Australia’s credit outlook is mixed. There has clearly been some excess in residential lending by the major banks, though APRA’s actions in 2016 did reduce this somewhat. Bank lending to corporates is generally of high quality. Infrastructure is the only corporate sector that seems to have weak lending standards like 2006/7. Acknowledging these negatives, Australia still remains something of a treasure island for credit investors offering far greater risk/return than is available in the US, Europe and Asia. One recent example of this gap was a 30 year, senior unsecured bond issued by CBA in the US at treasuries +1.03%. Australia’s comparatively conservative investors demand the same margin for a 5 year bond and would be unlikely to buy a standard bank bond with a maturity beyond 10 years.
Response to Current Conditions
Credit markets worldwide are currently paying little premium for lower rated debt, longer debt or subordinated debt. The herd mentality is to ramp up risk in each of these three areas in order to increase returns. The correct response is to run the other way. The focus for Narrow Road Capital remains on staying short (near term maturities) and staying senior. This should theoretically be costing returns, but it hasn’t been the case.
At the beginning of this year an institutional client came onboard with a mandate for a mix of investment grade and high yield credit securities. Taking into account the current environment, there is a heavy tilt to investment grade securities. The target returns of cash + 2.50% (high grade) and cash + 4.00% (high yield) have been beaten by significant margins. Substantial excess returns have been earnt in smaller, short dated, illiquid securities that will self-generate liquidity for the portfolio through amortisation and maturity. The portfolios are well positioned for a downturn, but also well positioned for continuation of the status quo.
Emerging Market Debt: Dumb, Dumber and Dumbest
One of the classic signs that the credit cycle is nearing the end is that borrowers that shouldn’t be getting financed not only get funded, but get it at terms that seem crazy. I’ve recently written about the silly things happening in global high yield debt, Chinese debt and the global attitude to sovereign debt. Continuing this theme are recent examples of emerging market sovereign debt; Greece, Argentina and Iraq. Each of these shouldn’t have been funded, but the desperation for yield saw all three get funded on terms that seem crazy. Here’s the detail on each.
Argentina
In June, Argentina sold $2.75 billion of US dollar denominated 100 year bonds at a yield of 7.92%. At the time, this was a mere 5.18% yield pick-up over 30-year US treasuries. Argentina has a long history of defaulting on its government debt, including 4 defaults in the last 35 years. The 2001 default took 15 years of negotiation and litigation to resolve, with most bondholders losing their shirts and a few who bought late and fought hard getting extraordinary returns.
The current outlook shows that not much has changed for Argentina. Inflation is running at over 20% and the government is aiming to cut the deficit this year to 4.2% of GDP, hoping to stimulate the economy out of recession. Investors are banking on the recent change in government to increase foreign investment and see sound economic management implemented. The need to reduce politically popular subsidies will be a major hurdle to that. S&P’s rating of “B” and Moody’s at “B3” reflect the country’s weak credit profile. Taking all of this into account, Argentina is unlikely to get through a decade without defaulting let alone 100 years.
Greece
In July, Greece sold €3 billion of 5 year bonds at 4.63%, a 4.78% yield pick-up relative to 5 year German government bonds. Investors have particularly short memories on Greece’s debt, with the 2012 default seeing bondholders take losses of around 75%. The 2014 issue of 5 year bonds traded as low as 56% of face value, a horrible ride for those who bought into it. The constant negotiations for further bailouts always come with the threat that Greece won’t make further concessions and this time the Europeans and the IMF might have had enough.
Greece’s position remains precarious, debt to GDP currently stands at 179%. The economy has been stagnant for years as its government continues to resist the structural reforms proposed by the IMF and Europeans. Some are optimistic as Greece recorded a primary surplus (before interest expenses) in 2016. However, to achieve a fulsome surplus Greece needs to be funded at around 1%, well below the 4.78% yield it is paying bond investors. Unlike the buyers of the recent bond issue, S&P (B-) and Moody’s (Caa2) don’t see good prospects for Greece paying back its creditors.
Iraq
In early August, Iraq sold $1 billion of 5 year bonds at 6.75%, a 4.93% premium to US treasuries. Iraq faces three major medium term issues; the ongoing war, export revenues reliant on oil prices and dependence upon military and financial support from the US government. Each of these is out of its control. The 2016 deficit at 14% of GDP shows Iraq clearly cannot service its debts without a substantial financial turnaround. By buying the bonds, investors have effectively banked the equity case of the war ending and oil prices improving. The credit ratings from S&P (B-) and Moody’s (Caa1) are a better reflection of Iraq’s economic prospects.
Conclusion
In considering emerging market debt, investors have to be careful to consider each country on its own merits. In the examples of Argentina, Greece and Iraq, bond buyers have suspended sceptical analysis. They’ve banked the equity case, hoping for a substantial change from historical precedents, even though they won’t get a share of the upside if the rosy scenario occurs. The examples aren’t unusual; as shown in the graph below from Bloomberg Belarus, Mongolia and Ukraine are all CCC+ rated but have bonds yielding less than 6%.
These examples point to the greater fool theory playing out in many credit markets. We’ve now reached the point in the credit cycle where further gains seem dependent upon more dumb money arriving and pushing spreads even tighter. Calling the top of any cycle is nearly impossible, but calling out the current higher risk/lower return environment is simply common sense.
Banking Bad: The China and India Episode
China and India are both getting excited about creating bad banks, but neither has an answer to the fundamental question that bad banks create. The key question is always, “who is going to take the loss”? The concept of a bad bank is easy to understand; you remove the bad loans from a bank thus allowing it to concentrate on new lending. The hard part of getting a recovery from the bad loans is hived off to someone else. The arguments usually begin when the price for the asset transfer has to be determined. The “good bank” wants the highest price possible so it doesn’t need to raise additional capital. The “bad bank” wants the lowest price possible so it has the best chance of making a decent return on the bad loans it has bought.
In well developed economies the market determines the price. The good bank offers the loan for sale and takes the price from the highest bidder. However, when there is a substantial downturn, or if the market for bad loans isn’t well developed then government intervention often occurs. In Ireland, Italy and Spain, the government has intervened and bought bad loans at a price well above what the market would pay. Taxpayers ultimately get stuck with the bill for the poor decisions of banks, regulators and politicians.
In China, there’s a group of asset management companies that exist to buy bad loans from banks. Whilst there is always an overlay of government intervention in China, the asset management companies mostly act as profit seeking entities paying a fair price for bad loans. This means that banks must be ready to sell the loans at a substantial discount (say 20-40% of the face value) which reduces the balance sheet value of their assets and equity. China’s banks aren’t ready for this and are looking for ways to avoid or defer taking this hit.
This year the value of debt for equity swaps has soared. Of the $150 billion completed so far, 55% has been from coal and steel companies. In theory, this process should force the banks to write down the value of the bad loans to their fair value as part of a swap, but there are a number of ways to game this. The regulator only requires banks to hold capital against the newly created equity at around one-third the level that would normally be required for the first two years. The naïve way of looking at this is that it allows banks additional time to raise capital to offset the losses. The more experienced hands call it kicking the can down the road.
Another plan the Chinese government is exploring is allowing banks to establish their own asset management companies. These would buy the bad loans at an inflated price, with external investors “partnering” with the banks to fund the purchase. This plan assumes that banks will find muppets to “co-invest” with them. Recent history in China shows that just about anything can be sold if there is a promise of a good yield.
It is believed that wealth management products are already being used for this purpose, with the banks packaging up bad loans and selling them at face value to retail investors. From a bank’s perspective, this is a fantastic outcome as the loan has moved off balance sheet at no loss. The downside is it becomes a powder keg for social unrest, when the investors realise they’ve been duped. Some investors are applying leverage to wealth management products to further juice returns, pulling banks back into the bad loans they think they have gotten rid of.
India wants to create more bad banks, but again no one has a plan to raise the capital required to cover the losses. Indian banks have around 10% of their total loans marked as non-performing. This might be the tip of the iceberg with India ratings seeing half of the country’s debt at risk of default. Charlene Chu estimated that one-third of all of China’s bank loans are at risk of default.
In the UK, subprime lender Provident Financial saw its stock fall 70% in a month after a flurry of negative announcements. It announced a substantial loss, halted its dividend, divulged that it was subject to a regulatory investigation and saw its CEO leave. The root cause of much of its problems was that it sought to cut costs by reducing the staff it employed in collections. As a result, its repayment rates dropped from 90% to 57%. It’s a reminder that credit is all about lending the money and getting it back.
Australia’s largest bank, the Commonwealth Bank Of Australia (AX:CBA) has been hit by yet another self-inflicted scandal. The allegations that it failed to report obvious money laundering and potential terrorism financing transactions is the worst offence in banking. In previous scandals in its financial planning and insurance businesses CBA was able to correct errors by paying compensation to victims. In money laundering, there’s no way to right the wrong. CBA has (allegedly) indirectly assisted drug dealers buy and sell drugs and helped terrorists buy weapons. It is not lost on financial regulators that drugs and terrorists kill people, with billions of dollars in fines issued in the last decade for this type of misconduct. The allegations in this case are similar to HSBC’s 2012 settlement that cost it US$1.92 billion.
Media Worth Consuming
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Google (NASDAQ:GOOGL) celebrates diversity by firing an employee who expressed a different opinion and pushing a think tank it sponsored to fire an employee that criticised it for monopoly behaviour. The YouTube subsidiary has economically censored former congressman Ron Paul as part of a pattern of attacks against liberals and conservatives. It also shut down the email and blog of a maths professor for no reason and paid refunds for ad fraud.
Morgan Stanley (NYSE:MS) finds that Tesla (NASDAQ:TSLA) cars create more pollution after including the emissions from electricity generated by fossil fuels. Tesla appears to be deliberately delaying refunds on Model 3 deposits. In Denmark, owners of electric cars can earn €1300 per year by selling power back to the grid at peak prices. Electric cars are spurring innovation in petrol cars, Toyota has lifted the miles per gallon by 25% on a new Camry.
Charles Barkley is labelled a “white supremacist” for calling for black people to “stop killing each other” and “worry about getting our education” instead of being concerned about statues. Should human beings be allowed to take revenge against robots? Why don’t politicians get sued for fraud on phony election promises? Today’s economic and finance news explained in layman’s language. The sugar tax makes beer cheaper than soft drink in Philadelphia.