‘Negative yielding debt balloons to $15 trillion’ – CNBC
No you didn’t misread that quotation, the value of bonds around the world that investors are willing to lose money by purchasing now exceeds USD$15 trillion. Is it simply the start of another trend, or is it something we should be concerned about?
Everywhere you look around the world investors are being forced into higher risk assets in the search for income and growth from their capital. They are doing this because unconventional monetary policy is bringing cash, bond and other associated interest rates ever closer to 0%. For instance, in Australia you receive just 0.8% on an at call account or 1.6% for a multi-year term deposit.
Why is this happening? Policymakers and economists believe that by making saving money such a poor investment decision they will be forced to consume, invest or generally stimulate the economy. Yet after a decade of these policies both the US, Europe and Japan are all staring at unexpected recessions. There is a growing consensus that these policies are simply inflated the value of risky assets and delaying the inevitable, a view we believe has some merit.
In this issue of Unconventional Wisdom we have sought to highlight both areas where we believe risk has been forgotten in this never ending search for yield and opportunities that offer more appropriate risk- reward profiles in this increasing difficult environment. For the remainder of this article, however, we will highlight and summarise a few key themes that are of growing concern to our Investment Committee.
One of the most interesting recent developments was the seeming repeat of past mistakes by the major credit ratings agencies around the world. It seems the multi-billion dollar fines issued following to many of these agencies following the GFC have not been enough to force a more transparent approach to risk assessment.
According to the Wall Street Journal, the introduction of more competitors in the credit ratings space has simply seen their recommendations become more aggressive in the pursuit of growth. For instance, the new competitors in the sector are consistently providing higher credit ratings than the old fashioned duopolies. As always, they are paid and employed based on the ‘recommendations’ they provide. Now, this may be well and good for institutions with their own risk management teams, yet as usual those most likely to lose out are the retail investors who inevitably end up in the products full of these newly issued bonds.
Along with credit ratings, the proliferation of margin debt, or margin lending in Australian terms, was one of the many factors that contributed to the eventual depth of the GFC. It is margin lending, where the only security offered for a loan is a portfolio of listed and therefore volatile securities that contributes to wild market swings.
This is because market falls result in margin calls on investor accounts and with most people unwilling to contribute additional capital at these times their portfolios tend to be sold off. As can be seen in the chart above, margin debt in the US has followed the S&P 500’s march to all-time highs, with levels now far exceeding those before the GFC and until recently, growing at a substantially faster pace.
Margin debt alone isn’t necessarily a bad thing and as many readers will now, if margin debt grows at the same pace as the market then the loan to valuation ratio should remain the same; so investors aren’t necessarily taking on more risk than usual. The bigger question in this case is whether market valuations are inflated, driven by ever lower interest rates, meaning the experienced volatility of these strategies may be substantially higher.
ETF’s, leverage and synthetics
The huge growth in ETF’s may actually be increasing the risk of margin lending strategies, as they tend to give no consideration to value, allocate more capital to businesses as they become more expensive and react automatically to changes in the market. Further to this, the search for yield and a growing concern for volatility has spawned an increasing number of leveraged and synthetic products. By leverage, we mean these ETF’s (and some managed funds for that matter) either borrow funds, employ long-short strategies or through various derivatives take your market exposure as high as 300% of the capital you invested. In terms of synthetic, this refers to ETF’s and listed investment companies that don’t actually hold the assets to which they provide an exposure. One example would be those securities offering exposure to the Volatility or VIX index and some single commodity exposures, which own futures or options, rather than the underlying commodities. It is yet to be seen how these securities will react when markets really get volatile.
Availability of illiquid products
As the search for yield intensifies, investors are increasing being offered less liquid products. For instance, the industry fund HOST Plus, recently launched an SMSF Invest option that allows their main competitors to invest into the Direct Infrastructure investment option. Interestingly, it has been this investment option, managed by Industry Funds Management, that has delivered c10% returns for the last decade and been the driver of that sectors out-performance over the same period.
So why now, after seeing interest rates fall from close to around 7% to 0% and increase the value of these assets substantially, has the fund decided to offer access to everyone else. In addition to this option, the likes of AMP Capital, Infrastructure Partners Investment Fund and many others are bringing these options typically reserved to pension funds to the masses. Is it a sign of greed, seeking to capitalise on the search for yield? Or is it really a good time to be investing in illiquid, interest rate sensitive assets.
Classification of risk
As is the case in any market boom, the classification of what is considered high or low risk becomes increasing stretched. One needs to look no further than the pages of Australian Financial Review and the many advertisements throughout. In this case, we aren’t referring to the regular plastering of the increasingly irrelevant, vertically integrated Evan’s Dixon financial advisers, but rather the series of products offering incredible yields as an alternative to term deposits. The case in point is IPO Wealth, an investment opportunity that is restricted to wholesale investors, or those with over $2.5m to invest. The headline itself attracts people due to the appearance of exclusivity; yet it isn’t exclusive at all. As an investor in IPO Wealth, you will receive a return of 3.75% on the 12 month option or 4.95% for the five year option; sounds great right? Perhaps if you are comfortable investing into high risk pre-IPO smaller companies, as that’s what your investment is used for. Your contribution to the fund will be lent to business seeking to list on the ASX in future years, many of which may not. According to external research the fund is structured such that if the investments are successful, your return will be capped, and if it is not, you will be fully exposed to the downside risk…..IPO Wealth has recently been joined by its sister company Mayfair Platinum, which appears to offer a similar product.
Complex Debt Products
The reduction in lending by the major banks has resulted in a surge in the non-bank lending sector. As the increased demand for loans increases, so does the need for capital. The result has been the likes of Wingate Partners, Trilogy Funds, Latrobe Financial and Think Tank, entering the market with high yielding products. Now we aren’t saying there is anything wrong with these products, but its important for investors to understand what they are investing into. The funds issued by each of these managers are used to fund loans, some simply mortgages but others mezzanine construction finance, unsecured corporate lending and the like. Further, many of these products are tranched in that different investors agree to different terms in the event of capital loss, in return for higher or lower expenses. The structures are complex and not for the uninitiated. Take for instance the recent bankruptcy of developer Ralan, which owed $500m to creditors including Wingate Partners and Westpac. We’d suggest these events will only become more regular in the years ahead.
We will highlight this in greater detail later in this issue, however, recent conversations with a number of industry participants raised some concerns about a number of highly popular investment strategies. The first was the growing Peer to Peer lending sector, where an investor is able to lend directly to a borrower, outside of the restrictions of a bank. This all sounds well and good, however, the question is why these people aren’t borrowing from a bank rather than paying the 10-20% interest they are charged. We heard anecdotal evidence of soon to be incarcerated borrowers taking out hefty loans, borrowers taking loans to pay out other loans and defaults increasing exponentially. The second case, was the recent ASX-listing in the ever popular Listed Investment Company space. The fund was promising an incredible yield through a diversified portfolio of loans to corporate businesses, but looking more closely the entire portfolio of loans was below BBB and not considered investment grade. As we highlight later, the probably of default as companies move from AAA to CCC grows quickly.
Inflated company valuations
Many people will say we are simply jealous that we missed out on the incredible growth of the likes of Afterpay; yet the companies valuation beggars belief. It doesn’t have a price earnings ratio because it has never made a profit. The company is now valued at $5.9bn, making it the same size as AMP, which has over $300bn in assets under management, yet all it does is offer a technologically advanced lay- by service. Of increasing concern is the manner in which investors are reacting to bad news in relation to this and other similar growth companies. When news of inappropriate loans, increasing delinquencies, the legal appointment or external auditors or reprimands from the Australian Money Laundering Task Force are announced, the company simply continues to march higher. What is most concerning to us in the case of Afterpay, has been the ‘changing of the guard’ that has occurred in last 6 to 12 months and highlighted by Commsec. Basically, the early backers of Afterpay, being institutions, fund managers and sophisticated investors, have been selling out quickly with the buyers being mum and dad retail investors trading through Comsec.
Companies reaching too far for growth
As experienced before the GFC, management and boards have a tendency to be overly enthusiastic about investment opportunities when money is cheap. Some notable examples last time around were the likes of Slater and Gordon expanding into the UK (and nearly going bankrupt), Newcrest buying the troublesome PNG Lihir mine and BHP Billiton making its ill-fated expansion into the shale oil sector. The story seems to be coming around again with a number of culprits domestically and globally popping up. Consider for example Japan Post’s purchase of Toll Holdings and subsequent writedown by $4.7bn, electricity retailer Origin Energy’s cancelled acquisition of telecommunications provider Vocus Group, after stating that its service was considered a ‘new type of infrastructure’. More recently Wesfarmers, free from its disastrous UK expansion and the sale of Coles Group, announced offers for a number of high risk commodity plays linked to the still unfounded battery storage thematic.
‘It’s only natural’
As Crowded House sang in 1991 during our last recession, it’s only natural that we should seek yield in an interest starved world. It’s all well and good to benefit from higher returns in the short-term whilst the economies supporting these markets remain solid, but will the relative peace continue? Or are we bound for a difficult period for markets? If your concerned about the US trade war or the growing likelihood of a global recession, it will pay to know exactly what it is you are invested into.