Most Australian investors have watched the recent gyrations in US and European bond markets with a feeling of relief that all this excitement doesn’t affect them, because they don’t own any US or European bonds. They have been watching the Grexit turmoil with similar emotions, because they don’t own any Greek bonds or shares. It is true that the immediate effects on Australian investors are modest, but we believe that these types of wild market moves are symptomatic of major underlying problems which will lead to further trouble in future.
US Treasuries and German government bonds are among the world’s safest assets. We can say this with confidence because their credit default swaps (which offer insurance against default) have long been priced more cheaply than almost all other forms of debt, even during the GFC. The safety of US government debt is what motivated finance theory’s concept of the “risk free rate” – i.e. the asset where you are sure what your return will be. When bonds like these suffer falls of up to 20% in their market value as a result of their yields rising 90 basis points, it signals that market perceptions of risk are changing for the worse.
What does the turmoil in global bond markets mean for Australian equities? The upcoming problems are the result of the ultra-low interest rates available to borrowers since the GFC. Companies and countries have been able to expand their borrowings because debt servicing costs are so low. At the same time, investors’ “reach for yield” has allowed many low-quality borrowers to access debt markets, because they are offering relatively high interest rates. The net effect is that there are a lot of bonds out there which should never have been issued, because the issuers are likely to default when global interest rates rise or if their own cash flows deteriorate.
The problem areas are not the “investment grade” bonds, where default rates are typically very low. Since 1920, according to Moody’s, the default rate on investment grade bonds has averaged only 2%. Speculative grade (“junk”) bonds are much riskier: their default rate often passes 10% in a recession, and it touched 14% in the GFC.
Greek sovereign debt has been in unofficial default since 2010, in the sense that that was when the supranational bodies the European Commission, the European Central Bank and the IMF started to lend Greece money to pay out its urgent private creditors so that it could reform its finances. Greece’s official default will be painful for the few banks which are directly affected, but it has long been anticipated by the bond markets, along with other basket cases like Ukraine and Venezuela.
The pain for investors in sovereign debt will come from unexpected defaults – that is, where a country’s finances have deteriorated so quickly that bond markets have not fully priced in the likelihood of default. Most of the problem areas here will be in emerging markets, where events such as domestic recessions or the Chinese economic slowdown have reduced a country’s ability to service its debt which is denominated in a foreign currency (usually USD). Another negative influence will be the eventual rise in US interest rates, which will not only raise loan servicing costs directly but will also support the ongoing rise in the US dollar against most currencies. Countries considered to be highest risk include Brazil, Colombia, Indonesia, Peru, Turkey and South Africa.
For corporate junk bonds, 2015 has already seen an upturn in defaults in some important sectors. The collapse of the oil price last year has put pressure on high cost producers worldwide, especially the US shale oil sector which relied heavily on debt financing. In China, the slowdown in GDP growth and the fall in house prices has triggered defaults from some property companies. We expect that corporate defaults will accelerate, for much the same reason as sovereign defaults – the negative effects of rising interest rates, falling Chinese demand and domestic recessions on foreign currency borrowings. As a general rule, corporate bond defaults tend to track sovereign bond defaults, because they spring from the same underlying economic causes.
Bond defaults, whether sovereign or corporate, impact investors’ risk tolerance very quickly. A single default causes bond portfolio managers to analyze their portfolios for any similar exposures, and the equity portfolio managers at the next desk will start checking their portfolios to see if they have any exposures like this. The impact is twofold: the re-assessment of risk means not only that previously ignored risks take centre stage, but also that all risks are re-priced upward.
In these circumstances, equity investors become more cautious too. They want to sell out of some holdings where they used to think that the risks were acceptable, and they want to be compensated for taking on new risks, i.e. they want lower prices.
The past history of the “reach for yield” in Australia means that, in the next downturn, many high-yield stocks will be vulnerable rather than defensive. The coming rise in US interest rates, coupled with the re-assessment of risk, will force investors to focus on the downside risks of stocks which have above-average yields but poor growth prospects. The sector most at risk in Australia is the banks, where organic growth has been hard to find outside residential loans and where further capital raisings are a certainty. Next come the utilities and infrastructure sector: in the periods between the standard five-yearly regulatory re-sets, the utilities stocks are very bond-like. The property trusts will also be negatively affected, but the impact will also depend on the growth prospects of their underlying markets. The sector as a whole is over-priced relative to book values, but there are big differentials in future growth rates between subsectors, as well as wide variations in trust gearing and the quality of their asset portfolios.
Neill Colledge
July 2015