Equity and hybrid investors react as bond prices tumble

Glenn Freeman | 24/11/2016

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Glenn Freeman: I'm Glenn Freeman from Morningstar and I am joined today by our senior credit analyst, John Likos.

John thanks for joining us.

John Likos: It's good to be here.

Freeman: Just firstly John we've obviously seen some quite significant market changes since the surprise election result in the US. Can you just talk us through that briefly?

Likos: Yeah, absolutely. I suppose that the key distinction between the Trump victory and what could have been the Clinton victory, is Trump's embracing a very expansionary fiscal policy in his initiatives or at least what he is proposing. Whereas Hillary Clinton would have effectively been pretty much status quo, much of the same.

So, the market is, aside from being taken aback by the result, is now repricing its expectations on future policy direction.

And in doing so is now expecting greater fiscal expansion and less emphasis on the monetary policy as has been the case for many years.

Freeman: And John, what's the reason for the shift in the correlations that we've seen between fixed income and equities?

Likos: Absolutely. So, what's now happened is as we've seen the sovereign, the bond markets have repriced significantly.

So, bond prices have tumbled at least among sovereign bonds and we've seen global yields all over the world increase sharply, and in the meantime equity has risen.

So, what we are now seeing is a return to that negative correlation between, well in this case treasury bonds and equities. So, bond prices are falling and stock prices are going up. As a result of the increasing expectation of fiscal expansion that Donald Trump wants to embark on.

And what this means and why this is happening is basically because inflation is a greater risk when you have fiscal expansion, and inflation is the bond market's worst enemy.

So, that is scaring bond investors whereas equity investors love the sound of spending money on infrastructure or what have you. And are expecting greater growth, economic growth and are therefore buying up shares and selling the sovereign bonds.

Freeman: And John, within the Australian context, can you also explain for us the distinction we see between hybrid products and traditional fixed income.

Likos: Absolutely. We discuss this at length in our hybrid handbook, which we recently released. The clear distinction is the traditional fixed income product is far safer, less volatile product than the hybrid.

In the case of a bankruptcy, your traditional fixed income investor will probably get back about $0.40, $0.50 in a $1.

Whereas a hybrid investor will probably get $0.05 in a $1 at best. Just to put that in context in terms of recovery value and how they sit on the risk scale. In terms of their features, and their structure, and their characteristics, I suppose the biggest difference is hybrids in Australia tend to be floating rate notes.

So, they have floating rate coupons, they have margin on top of BBSW rate, the benchmark rate. Whereas many traditional fixed income securities have a fixed coupon.

So, no matter what happens to benchmark rates that return amount remains the same. In many ways a hybrid investor is protected against interest rate risk or increasing interest rates, because the benchmark rate will go up.

That’s one clear distinction in terms of pricing and that’s again why we are seeing hybrids holding up really well. Whereas your fixed coupon bonds again particularly at the sovereign level are getting hit very hard.

Freeman: And just finally, now that we are almost at the end of 2016. What do you see on the horizon as we move into the first quarter of next year?

Likos: I think volatility is going to continue to be a theme. With President-elect Trump, he has a lot of ideas, but it's still going to be hard to actually execute these because there is a lot of hurdles he has to go through within the U.S. government.

So, he still needs approval by his own House effectively and that’s no guarantee that all the Republicans are going to vote in favor of a lot of what he is proposing and suggesting.

We're going to have some hurdles. We're going to have some roadblocks and the markets will continue to reprice expectations on the back of that. Australia is going to continue to be led by what's happening in the US.

However, if we look more domestically than, look I still think we have a pretty strong economy. I think unemployment is something we need to keep an eye on as a key risk. But I do expect the markets to continue to trend upwards over time despite this volatility in the meantime.

Freeman: John, thanks very much for your time today.

Likos: Thank you.

Freeman: I'm Glenn Freeman from Morningstar and thanks for watching.

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

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