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Debt securities’ upturn continues

Photo of Philip Bayley, Australia Ratings By Philip Bayley, Australia Ratings

min read

Australia Ratings indices highlight improving returns in ASX-listed debt securities.

Investors in ASX-listed debt securities enjoyed strong returns in 2016. It was compensation for the poor returns in 2015 and reflects the opposing forces driving the market in each year.

The search for yield, as interest rates continued to fall, and a lack of supply as redemptions exceeded new issues, particularly towards the end of 2016, drove up prices among listed debt securities.

It seemed 2015 suffered a hangover from the excesses of 2014 and earlier years. New issues had been abundant and credit margins had been steadily compressed.

This culminated in October 2014, when Commonwealth Bank listed the $3-billion PERLS VII (CBAPD) hybrid notes, paying a credit margin of just 280 basis points over the 90-day bank bill rate. This was the largest issue and the tightest credit margin the market had seen, and has not been repeated since.

Credit margins widened throughout 2015 and into 2016 as the market digested supply and repriced credit risk.

Thus, total returns to listed debt investors in 2015 ranged from modest to negative. Security prices generally fell over the year and positive total returns required distributions paid to exceed the fall in the price of the securities held.

Solid returns in 2016

Australia Ratings’ Combined index for ASX-listed debt securities shows a return of 8.04 per cent for 2016. In 2015 the return was a negative 0.75 per cent. It is an accumulation, or total return, index and considers both price movements and distributions paid over time.

The Combined index covers all non-government, ASX-listed debt securities that pay floating-rate distributions and have more than one year to go before reaching their call or maturity date. The Combined index is the largest and main index in a family of indices based on the product complexity indicators (PCIs) used by Australia Ratings – green, blue, yellow, orange and red.

Australia Ratings has assigned credit ratings and product complexity indicators to most listed debt securities.

The green index covers simple, senior-ranking debt securities and the blue index covers simple subordinated debt securities. The latter has been suspended, as there are no securities rated by Australia Ratings that currently fit this category.

The yellow index covers securities with deferrable but cumulative distributions, while the orange index covers securities with deferrable, non-cumulative distributions. The orange index also includes securities with a non-viability trigger for recapitalisation of the issuer.

The red index covers those securities with these complexities and a capital event trigger, as found in bank-issued hybrid securities.

Australia Ratings also produces franked and unfranked indices to isolate the differing performance of securities that pay franked distributions relative to those that do not.

Indices performance review

Chart 1: Australia Ratings Indices Annual Returns – 2015, 2016 and total

bayley-graph-1

Source: ADCM Services, Ord Minnett

The red index generated the strongest returns in 2016 and indeed over 2015 and 2016 combined, but has also had the greatest volatility. The total return over 2015 and 2016 is 10.02 per cent, being the product of a return of 9.96 per cent for 2016 and just 0.05 per cent for 2015.

The red index encompasses the highest-risk debt securities listed on ASX. The green index encompasses those of the lowest risk, yet this index is the second-best performer with a total return over 2015 and 2016 of 8.39 per cent.

The total return for the green index is made up of returns of 0.77 per cent and 7.56 per cent in 2015 and 2016 respectively. It is arguable whether the difference in the returns from the green and red indices is commensurate with the difference in risk between the indices.

It is also interesting to observe that the less risky yellow index has produced superior returns in both 2015 and 2016 to the riskier orange index. And similarly, the unfranked index has produced superior returns to the franked index over the two-year period.

Curiously, more than four times the number of securities are included in the red index than there are in the green, yellow and orange indices. Does this suggest that issuers believe listed debt investors want only higher-yielding securities or that only the riskiest debt securities are sold in this market because there is little or no demand in the wholesale market?

Chart 2: Australia Ratings index performance 2015 to 2016

Source: ADCM Services, Ord Minnett

A sharp uptick in performance between November and December 2016 can be seen in each of the indices. Origin Energy redeemed $900 million of subordinated notes (ORGHA) in December, while Insurance Australia Group issued just $404 million of capital notes (IAGPD).

This followed the redemption of $700 million of subordinated notes by Woolworths (WOWPC) just the month before. The holders of the redeemed notes have been looking to the secondary market for other investment opportunities.

Of course, as investors drive up security prices, returns in the form of yield to call/maturity are compressed, as can be seen in Chart 3 between November and December 2016.

Chart 3: Weighted average index yields 2015 to 2016

Source: ADCM Services, Ord Minnett

The weighted average yield for the green index at the end of December was 3.57 per cent per annum. For the yellow index the figure was 6.39 per cent; the orange 3.88 per cent; and the red index 5.84 per cent. The Combined index had a weighted average yield of 5.57 per cent per annum.

The difference in the weighted average yields of the yellow and orange indices reflects the presence of the longer-dated, out-of-favour Crown Resorts Subordinated Notes II (CWNHB) in the yellow index, and the relatively short term to call for the securities in the orange index.

Outlook for 2017

Further secondary market price increases can be expected in 2017, as redemptions are expected to outstrip the supply of new issues by as much as $5.4 billion.

Hopefully, this possible shortfall and consequent increase in investor demand will attract many new issuers to the market and thereby reduce the pressure on prices in the secondary market.

While any increase in interest rates will have little impact on the price of securities that pay floating-rate distributions, any increase in risk aversion will also temper price increases.

About the author

Dr Philip Bayley is a director of Australia Ratings and the principal of debt capital markets consultancy, ADCM Services.

From ASX

The ASX Bonds page provides information on the features, benefits and risks of various debt securities.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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