Watching Interest Rates to Understand Equities

The latest chatter about the steepening of the yield curve between the yield of the US Government 10 year bond (minus) and the 2 year bond is no big deal.

That differential (“the spread”) is currently at 1.56%, 

(that’s how much the 10 year bond is yielding above the 2 year bond and it is represented in a plotted graph, we call the yield curve)

Yes, it’s the widest spread since September 2015, but it’s not extraordinary.

It has been twice that amount (3%) on several occasions over the past 30 years. (see chart below)

There is some exaggeration about how steep the curve is…it actually isn’t.

Don’t worry too much about that yield curve at the moment.

My story is about when the spread actually touched Zero (which is when the 10 year bond was offering the same yield as the 2 year bond) and not so much the actual spread nor the yield of the 10 year bond.

And then I have added comments to what happened to the equities market afterwards.

Example #1

In April 1998 the spread touched Zero,

but the S&P 500 continued to rise until the S&P 500 peaked in March 2000; some 21 months later.

A year earlier, in April 1997, the 10 Year Bond (“the 10’s) was yielding 7%. 

By April 1998 it had fallen to 5.6% (when the spread was Zero)…..

the yield would decline a little more, down to 4.4%.

By March 2000, it had climbed back to 6.66% to coincide with a peak in equities market.

Example #2

In January 2006, the spread was at Zero again, but stocks rallied for a further 17 months until the S&P 500 peaked in October 2007.

From that moment in January 2006, the 10’s rose from 4.3% to 5.3% on a couple occasions, reaching that same 5.3% peak in July 2007, just as economies were about to experience the ‘Global Financial Crisis’.

For a period of 6 weeks, the 5.3% yield did break above the downward sloping trend line (see the chart below) but the precedent of a Zero spread being registered 17 months earlier held sway.

Example #3

By December 2008, 10’s had fallen to 2% (although the spread didn’t flirt with Zero, it never went below 1.2%).

From this ebb, the yield doubled to 4% over the next 18 months (April 2010).

The stockmarket fell 20% over the next few months.

Example #4

Through stages of the GFC recovery, 10’s were back to 1.4% in July 2012.

Within the next 18 months (by December 2013), the 10’s doubled to 3%

The stockmarket rally was stifled and went sideways for 5 months.

Even though rates doubled, equities remained in a bull market because we never saw a Zero spread registered.

Equities resumed their rally as 10’s commenced a new decline in yields from 3% down to 1.7% over the next 14 months, being until January 2015.

Note: The United States Federal Reserve kept the Fed Funds Rate at Zero between 2008 and 2015.

Example #5 (the anomaly)

By July 2016, 10’s eased a little more to 1.35%. From there, they nearly doubled again (to 2.6%) within 5 months and then touched 3.2% by November 2018.

Although rates nearly trebled…..they never registered a Zero spread reading. Furthermore, the anomaly is that the 10’s yield broke above the sloping downtrend resistance line (see chart below), which gave the S&P 500 ‘carte blanche’ to rally….all until the 10’s yield crossed back beneath that (now and new) support line in the month of August 2019.

Example #6

In the next month, September 2019, saw another Zero spread registered. 

While absorbing an abrupt correction, the S&P 500 has soared and continually set new all-time highs, 18 months hence.

Today, the 10’s have Quadrupled from their 0.40% March 2020 low, to its current 1.72%.

Uncannily, we are 18 months further along since the spread touched Zero and we have seen an equity market participate in extraordinary gains…….

I will re-iterate…….the interest cost of government debt has Quadrupled within 12 months.

That matters to investors and to the government servicing the interest payments.

But we are at a moment, similar to the anomaly explained in Example #5.

Forget the ’spread’ and steepening yield curve, but let’s say the 10 year bond yield reaches 2% and decisively breaks above that sloping downward line, then it’s plausible that the S&P 500 rallies for a further 18 months.

This bullish scenario may represent the ‘last leg’ in the 11 year bull run which commenced at the March 2009 low.

Although, greater probability suggests (coinciding with fundamental valuations and various sentiment and anecdotal indicators) that the quantum of quadrupling interest rates will prove a greater weight on equities plight for further gains. 

This is the measured reason why I have shifted client equity portfolios to 35% cash position and hedged portfolios with put options. This was mentioned in my January 2021 newsletter.

March 21, 2021

by Rob Zdravevski

rob@karriasset.com

Why buy bonds at -0.01%?

Do you remember during the European debt crisis, which peaked around 2012, when the PIGS (Portugal, Italy, Greece & Spain) were being bailed out by the European Central Bank?

In the chart below, you can see the Portuguese 10 year Government Bond was yielding 14% at that time.

I didn’t have the inclination, acumen or guts to buy those bonds then and nor since.

But today, that bond has traded at a negative yield of 0.01%.

How times have changed.

Some investors have felt that such a yield is so ravishing that they decided to buy the heck out of those bonds to the point where they will happily receive a zero yielding return.

I can’t figure this out and nor do I have answer.
It’s simply an astonishing occurrence.

December 9, 2020
by Rob Zdravevski
rob@karriasset.com.au

How did Sydney Airport shareholders not see this coming?

Well, I got that wrong !
Only 6 weeks after I wrote this post, Sydney Airport didn’t choose to raise more debt to pay its interest coupon…..

even worse, it’s raising $2 billion in equity.

Debt is typically cheaper than equity in this current environment, but this tells me that Sydney Airport’s debt financing has dried up.

Worryingly,  with its growing debt burden, evaporated revenues and worsening equity valuations, the importance of this strategic asset will mean that government support will provide a perennial floor in the share price.

oh dear !

by Rob Zdravevski
11 August 2020

 

 

Neither a borrower nor a lender be

The genius of James Packer continues.

Crown Resorts is a BBB rated company and they have raised $600 million in debt through the public markets at 4% above the bank bill rate, which means currently the total coupon will be 6.27% range.

The paper matures in 2075 but Crown can redeem them in 2021. Lenders own debt which is subordinated. They will rank below preference share holders and other capital market debt but above ordinary shareholders. The money is going to be used to finance projects within Crown Sydney & Crown Towers Perth.

So what they have achieved is to reap a stack of long dated capital at a cheap price without the onerous banking liens and it was raised easily because investors are simply chasing any yield.

Investors should consider not whether they are being “paid” enough to take this risk as a lender but whether they have considered the risk/return (even the risk of underperformance) of owning the shares of Crown Resorts rather than its debt would a better proposition. I’m not writing about Crown’s risk or ability to pay its coupon or return your capital but whether the herd has simply filed into another hybrid income product without thinking about it.

Think of it in terms of the return shareholders may receive as a rate of return over the cost of the capital once they complete the expansion of the various casino projects?

I forgot to say that James Packer’s family company, Consolidated Press Holdings (CPH), also bought $50 million of this debt. I’m sure this gave the new debt investors added confidence that he has backing it personally.

That’s fine, but CPH also owns at least $4 billion of Crown Resort shares.

Sometimes analysis is difficult and sometimes it can be simple.

The Coming Slaughter of the Yield Pigs

Dollar in Piggy Bank

Major Australian banks have again raised billions of dollars by issuing debt.

In some instances, the issuer of the debt isn’t the parent company and in cases where it is, investors should wonder why do the most creditworthy banks in the world need to offer 300 basis points (or greater) above their benchmark rate, in order to attract investors?

Perhaps it’s because the debt is perpetual, its pays non-cumulative distributions, its unsecured and subordinated

Other questions to ask include; what is the credit rating of the debt, is if the credit rating of the debt is different to the issuer, when does the debt mature, can it be “called” or “converted”, are distributions franked, am I being paid fairly or enough for the risk I am taking or perhaps simply, does this investment benefit you or are the odds stacked towards the “house”.

I also question whether I should buy it at “par” rather than a discount.

Sadly, many Australian retail investors don’t possess the required skill and knowledge to analyse debt investments.

In turn, they often aren’t receiving objective advice,. Instead, they are often being “sold” the investment rather than being advised whether it’s appropriate for their portfolio.

There has been plenty of debt on offer, so I ask myself, why should I buy something that has ample supply?

The genius behind the banks decision is to raise capital when they don’t particularly need it and they do so when their costs (or the rates they offer) are cheap.

Australian interest rates are now at record lows with the current Reserve Bank rate sitting at 2.5%.

With the pendulum at an extreme, there is greater probability that interest rates triple in the next 10 years before they move to 1%.

Are these investors buying something at the wrong end of the cycle?

The great U.S. corporate bond issuance

Singularly, you may not have noticed various U.S. companies either re-finance existing debt or importantly issue new debt, over the past year or so.
Collectively, it is a monumental amount of debt.

Cleverly, these companies have taken advantage of the almost perpetual low yields of the government benchmarks, upon which they can base their spreads against.

Companies such as Oracle, Amazon & Goldman Sachs have issued bonds either secured or unsecured against their equity at historically low yields; which is brilliant financial strategy for these companies.

With interest rates at such low levels, probability and cycles suggest that rates will rise in the coming 6 years or so.

When 10 year benchmark rates are 6% and not 2%, I can’t see a 10 year 2.5% coupon Oracle Corp. bond being redeemed early, meaning bond holders will probably suffer capital losses unless held until maturity. Just imagine holding a bond that yields 2.5% into the latter half of this decade while others are earning twice or three times that amount?

Although, we are seeing a great bond issuance cycle, capital markets will most likely miss out on the next re-financing cycle.

What happens then?

Perhaps, companies will payout maturing debt by selling their own shares, which incidentally, they accumulated in share buy-backs conducted in 2012/2013 using the cheap money that they obtained from the same investors who bought their bonds?

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