Demand and supply for credit ILBs

Introduction

Discussions with our investors on the recent “road-show” on ILBs has highlighted many issues, including what the relative demand and supply conditions might be within the credit ILB market. Accordingly, we consider these issues below, along with providing some context for the outlook in government ILB markets. More specifically, this piece looks at the following specific issues:

• historical context and historical yields for the bonds under consideration,
• government bond outlook, including forecasts, and
• demand and supply in the credit ILB market, including forecasts for the Sydney Airport 2030 ILB.

Finally, we draw these various arguments together, as they specifically relate to the needs of investors.

Historical context

Since the financial crisis yields have fallen, even though equities have recovered significantly, as financial markets have sensed an ongoing presence of deflation within the advanced economies. Deflation is the problem for financial markets as consumers reduce debt and asset prices continue to slump, especially in Europe. Some economies, like Japan, are trying to escape deflation through aggressive quantitative easing as they follow the lead of the US authorities.

More recently, week after week, we continue to receive lower revisions for official forecasts of European and global growth, even though US growth is proceeding. At some point the ECB looks poised to assist the European system as economic growth is not only in retreat, it is plummeting.

So, if you think you have seen it all, then you are probably incorrect as even more aggressive easing by central banks is going to be required. In other words, more of the same, more of the easing that we have recently seen is the order of the day, and this means, apart for other things, that Quantitative Easing (QE) is here to stay. Lessons have been learnt from Japan, and those lessons are all about the costs of interrupting an emergent expansion; early withdrawal of QE would interrupt the emergent US expansion, thereby triggering additional costs for the Federal Reserve, and other central banks.

All this tends to explain why yields have fallen since 2009
(as demonstrated in Figure 1 below), as the ongoing struggle to stimulate growth has not had sufficient traction. Higher yields are more consistent with the failure to recognise deflation, as seemed to exist in the earlier part of the enclosed time series. Investors have woken up to the existence of deflation, and more is to come,

Figure 1

Government ILB outlook

In considering the outlook for government ILB real yields the general economic outlook is most important, for both Commonwealth Government (CGL) and Queensland Treasury Corporation (QTC). The key points are as follows:

• regional growth proceeding, yet challenge remains given ongoing European recession and slow US growth,
• deflationary forces linger and remain difficult to offset, as growth slowly builds in the US, and sags in Europe,
• RBA to ease to 2.50% in 2H13 and leave policy unchanged, at zero real, assuming no downturn in US recovery,
• if the US falters, as we suspect that it might as a result of fiscal drag, even further easing by the RBA might be expected,
• trend growth slowly emerges for Australia over 2014, yet no surprises to the upside despite the inveterate tendency of equities to try and pick this upside,
• yield advantage of AUD still attractive as other rates remain low, and
• US dollar resumes weakness as US falters from fiscal drag towards the end of 2013.

Forecast CGL ILB Real Yields

The above factors are generally supportive of CGL ILB yields returning to the old lows in terms of real yield, as the economy continues to struggle with low growth and global deflationary forces (see Figure 2 below):

Figure 2

Forecast QTC ILB Real Yields

For many of the same reasons, we see the demand for semi-government ILBs remaining firm over the next year, with the following path of real interest rates generally expected (see Figure 3 below):

Figure 3

In other words, the outlook for government ILB rates is for renewed interest in the ILB market, with low growth supporting low real yields.

Forecast Credit ILBs: Demand and Supply

Now that we have painted the general outlook for government linkers, we can begin to consider what the prospects might be for corporate ILBs. Here, with regard to the forecast for the Sydney Airport 2030, we argue that while economic forces are strong influences on yields, the demand and supply of this bond really need to carefully considered. Even though we mentioned some of this last week, we can restate these points more effectively, in terms of how they each impact the relative demand and supply for credit ILBs, as follows:

Demand for credit ILBs:

• investors are beginning to think more carefully about inflation as a primary risk in portfolio construction, and credit ILBs are the natural choice for investors who recognize the significance of inflation risk,
• rates are expected to say lower for longer, meaning that credit ILBs will produce what investors need; generous “real” returns, while term deposit spreads gradually moderate,
• restrictions on institutional mandates are gradually lifting, leading to a gradual widening of institutional interest in credit ILBs,
• institutional managers are beginning to market “real return” funds, which target returns above inflation. While not constrained to ILBs, such funds will eventually purchase credit ILBs,
• rates near 4% real remain very attractive, as 4.5-5.5% real is the target rate of return for sovereign wealth funds, who target “long term stable cash flows with an inflation linkage” (Future Fund Briefing, February, 2013), and
• credit ILBs represent conservative investments with typically solid investment grade ratings, and FIIG will continue to monitor these credits carefully, so as to keep our investor base fully informed.

Supply of credit ILBs

• new ILBs issuance will remain low, as issuers see them as being expensive to issue, relative to nominal bonds of similar tenors. If rates fall, then that may change, yet at this point the scope for additional issuance is somewhat limited,
• another factor constraining new ILB issuance from corporations is the current lack of institutional participation, although that will increase over time and may allow some new issuance next calendar year,
• ownership of credit ILBs has changed with the GFC, from highly concentrated institutional managers who can, and will, sell for a variety of possible reasons, to smaller investors who are not interested in ongoing trading of the securities. Hence, the holders of bonds, who might supply bonds to the secondary market, are arguably less prone to trade credit ILBs and thereby less prone to add to market volatility, when compared to the institutions that dominated holdings before the GFC, and
• mandate changes subsequent to the GFC are gradually being executed, so that the institutional selling that we had seen is now quite limited.

Weighing up the demand and supply factors, in the context of ongoing low rates, we estimate that the Sydney Airport 2030, as an example of the credit ILB asset class, should continue to do what it has done for the last year; fall in yield (see Figure 4 below):

Figure 4

Conclusion

Many things have changed since the GFC, and the demand and supply of credit ILBs is one case in point. Before the GFC, the credit ILB market was dominated by institutional investors, who were impelled to execute the directions of investment consultants in the light of limited CGL issuance. When the Commonwealth returned to the ILB market, as a major issuer, the demand for credit ILBs fell and then investment consultants reacted swiftly, which effectively left the credit ILB market out in the cold.

However, what is “trash” for some is “treasure” for others, and FIIG has uncovered the “treasure” in credit ILBs having now guided these securities into a diversified client base; a client base who have a long term view in terms of the role of ILBs in the portfolio. While the credit ILB market started with great promise, it suffered initially. However, the market is now set for even more consolidation, with more of the inherent value of the securities to be competed away over the next twelve months.