FIIG Investment Strategy

Risk on? Far from it. Now is the time for fundamentals.

Asmita Kulkarni, Director – Investment Strategy Group

Asmita Kulkarni

10 minute read

Risk on? Far from it. Now is the time for fundamentals.

The last couple of sessions have seen risk sentiment return to the market. So, does that mean it’s time to pile back into risk? We think it’s too early for that and caution investors to not sway far from fundamentals.

This document has been prepared by FIIG Investment Strategy Group. Opinions expressed may differ from those of FIIG Credit Research.

Background

The last two trading sessions have seen credit spreads crunch in on the back of positive market sentiment. The fiscal stimulus announced by various governments around the world, including United States and Europe, has stymied the equity market free-fall with credit spreads also moving considerably lower in the past two days. The chart below shows the movement in spread of Australian and US investment grade CDS indices. Despite this rally, we believe risk assets are far from bouncing off lows. We are seeing a bear market rally, which is often followed by a fresh move lower.

While it is not the time to add further risk to portfolios, we do believe it is the time to consider fundamentals offered by a company and trade on these fundamentals. Please refer to the next section for details.

Credit spreads (bps)

Credit spreads (bps)
Source: Bloomberg

Time to look at fundamentals of credit

Corporate bond markets remain very much dislocated and in the last few weeks pricing has not necessarily reflected the risk of the underlying credit quality.

Below is a visual representation using a simple traffic light approach to assess the credit quality of 25 different issuers. This exercise is aimed at analysing the likely negative impact of the Covid-19 pandemic on a given company. The assessment, prepared by our Credit Research team, is purely credit based, and does not opine on the current price of a bond. To put it differently, if a company is assigned a green classification then that reflects the fact that it will likely be fine for the next few months, amber depicts some likely headwinds that a company should be able to manage and red means the company is likely to face difficulty.

  Status Comment
AMP

Post-sale of AMP Life (assuming it goes ahead), AMP’s Tier 2 notes will only be recognized for regulatory capital for its banking operations. So while the group is under some pressure (particularly wealth management), AMP’s banking operations are very sound, with NPAT of ~140m and a Tier 1 capital ratio of ~12.5%. The bank has ~450m in capital (common equity and hybrids; equivalent to around 3-times full-year NPAT) that would be available to absorb losses before losses would be imposed on the bank’s tier 2 capital instruments.

Armour Energy

Armour is highly exposed to domestic gas spot prices which have fallen significantly as a result of oversupply in the domestic market. The company has limited ability to absorb additional costs or lower earnings over a prolonged period.

Australian Gas Network

Operates essential services with limited immediate impacts.

Australian major banks (ANZ, CBA, NAB, Westpac)

Well-funded and capitalised. Intervention from central bank has calmed interbank funding markets, improving liquidity and spreads. Central bank will continue to intervene as necessary. Bad debts and provisions will increase in the near term across the board (personal, small business, and corporate), but a decade of benign operating conditions provides a strong base with which to absorb increased credit costs. Dividends likely to be under pressure in the near term, however.

Centuria Capital

Minimal impact on earnings with a sound liquidity profile. Predominantly real estate healthcare, industrial and office assets backed with high occupancy and strong tenants such as Woolworths, Federal and State Governments, Target and Visy.

CML Group No material drop-off in trading to date, however, lower volumes being experienced. Current receivables financed with LVR of ~60% LVR. ~90% of receivables covered by trade insurance. Well-funded. Good headroom above covenant requirements.
Elanor Adequate liquidity with exposure via its Retail and Hotel, Leisure and Tourism business. Generates stable source of recurring revenue from funds management.
Lucas In the current environment, the industry Lucas operates within should be less impacted than other sectors. As this stage there have been no material impacts to current contracts with the company actively managing its FIFO and interstate workforces. However, given recent operating challenges, we believe that Lucas is limited in its ability to absorb revenue shocks or additional costs.
Maurice Blackburn No impact on earnings, with the Company expected to have a stronger 2H20. Additionally, expect an increase in work, especially from MB's Employment Law segment. But earnings could potentially be delayed.
Merredin Merredin had sound liquidity and receives availability based payments, COVID-19 will have little to no impact - BAU.
Newcastle Coal Infrastructure Group Solid liquidity with minimal near term maturities, operates take-or-pay contracts and therefore limited impacts.
Next Gen All clubs have been closed with no primary source of revenue, as memberships have been postponed.
NextDC Sound liquidity profile with an increase in demand for core services. Significant capital expenditure in the next 12 months funded through a mix of cash and credit facilities.
Omni Bridgeway Business largely insulated from current events and earnings generally coming 2 or 3 years after initial investment. Good liquidity.
Plenary Bond Looking at the contractual structure, nature of the assets in the portfolio and experience of Plenary means in the context of COVID-19, performance of the projects supporting the Plenary notes should remain solid. However, there remains the possibility of some cash flow interruption should equity distributions fall below forecast levels but this wouldn't be expected to affect servicing of the notes.
Praeco Operates defence headquarters so should have limited impact, strong contractual protections in place.
Privium No impact to earnings, but revenue is heavily weighted toward developments, with limited capacity to absorb severe downturn if developments or settlements are delayed.
Royal Women's Hospital Being a hospital, RWH could face some operational impacts associated with ensuring safety (additional cleaning, increased staffed hours etc) however, there are strong contractual protections in place.
StockCo No impact at this stage. Many of StockCo's clients are already operating under quarantined-like conditions and recent rain has pushed prices up as producers look to restock
Sunland Potential impact on earnings if developments are delayed. However, Sunland has ample cash and access to credit facilities with a sound balance sheet.
Sydney Airport While impacted by low passenger traffic volumes and significantly lower revenues, Sydney Airport has approximately AUD1.37bn available liquidity and AUD600m due to be funded in June 2020. As such the Company has access to funding sources more than sufficient to cover the AUD1.3bn expiring debt over the next 12 months.
Virgin Despite significant cash on balance sheet, the company remains heavily exposed to impact of COVID-19. Virgin has announced a 90% reduction in domestic travel and the cessation of Tiger + International routes through 14 June 2020 which will have a material negative impact on earnings.
WA Stockwell Adequate liquidity with recurring fee revenue tied to non-discretionary consumer staples. Earnings could be affected if smaller tenants are unable to main rents.
Zenith Energy Zenith has sufficient liquidity and operations should remain largely unaffected by current situation with COVID-19.
zip Money Some likely pressure regarding unsecured consumer finance which could affect zip in its capacity as servicer but Notes are part of a warehouse which relies on dedicated pool of receivables with clear eligibility parameters and credit enhancement in excess of minimum required.

Conclusion

Our Credit Research team will be updating this list to include new names and we, the ISG team, will also provide a view on the relative value of a list of bonds taking both the Credit Research and market pricing into consideration.

Understanding company fundamentals is important in any market correction as this allows investors to identify trading opportunities. For example, the names identified as being green in the list above are best to sell if liquidity is needed as market pricing on these names is likely to be less dislocated. On the other hand, if you are getting paid well for the risk the names in both green and amber above are good investment opportunities.

We will provide updates on our views via our regular publications such as Smart Income, so please keep an eye out for it or contact your Relationship Manager for further information.

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