Super-sized rate hikes, super-sized credit risk,
super-size problems. Follow the dominoes.
Jamieson Coote Bonds
The change of policy in 2022 has set off a series of dominoes for asset markets. Government Bonds were first to fall in quarter one, with other assets also following aggressively into quarter two. Listed assets are marked to market instantly (which can often be unpleasant) whilst illiquid or private markets can hold previous asset valuation marks as there is no observable price where price discovery could occur. It is worth considering what those realisable values might be if higher quality or liquid public assets are already -10, -20, -30%?
Is a credit crisis about to erupt?
The dominoes of change are quickly bringing attention to credit default as it stands to reason that refinancing outstanding lowly rated corporate debt will become increasingly problematic. The Australian Government was borrowing 10-year money at 1.05% in August last year, these rates have now moved to over 4.05% today. If the Government has to pay over 4% when it used to pay a bit above 1%, then spare a thought for corporate borrowers who might have borrowed at super low rates and are now asked to refinance at Government Yield of 4% plus some large credit spread component. How long will the markets have confidence in these lowly rated corporates to refinance at such punitive interest rate levels? The danger here is that they cannot ROLL those existing borrowings forward. That means there is no further credit extended and they need to REPAY the initial borrowing amount as well. That is exactly how a credit crisis erupts.
This is the policy pivot we have written about for some time and has marked a turning point in asset performance. But how does a Central Bank do that here with inflation globally between 5 and 8 %? Central Bankers are now rapidly raising rates as fighting inflation has taken absolute priority over saving corporate zombies from bankruptcy, generating material stress in the credit complex as many investors flee the asset class.
Credit risk has been spectacularly dormant as the broad decline in long term Government Bond yields since the 1980's, plus support from Central Banks, has fostered a "begin" environment for the assets class, slingshot by the massive support of flows and investor sponsorship in the ''search for yield'', under the financial repression of low interest rates. That sponsorship and flow looks likely to have ended with rates markets having a stunning sell off this year, leading most asset markets to weak performance. Many public credit assets have also underperformed - primarily from their inherent fixed income duration, rather than the material recalibration of credit (spread) risk.
The US Fed moved to 1.75% this week and suggested its next move is either 0.50% or 0.75% hike to 2.25 or 2.50% in July to continue the fight against inflation by killing demand in the economy.
The forces corporate credit markets are now facing
So, the next complex issue facing markets will likely revolve around credit default and the stunning rebirth of credit risk in the corporate credit fixed income space. Credit is a high specialised market which is little understood by most investors. Credit quality, as measured by ratings agencies, ranges from the highly converted (but low yielding) AAA rated issuers, all the way through to lower CCC rated issuers classified as having substantial risk of default (known in markets as 'junk'). Due to the inherent credit risk in these lower rated securities, yields are far higher to entice investors to take on the risk of default.
Any such support for the market looks very difficult to achieve this time as Central Bankers are now rapidly raising rates to fight inflation.
Would you lend money to a buy now pay later platform or a growth company with no sustainable earnings to meet debt repayments in the current environment? Thankfully for Australian investors we have very few names like this, but our corporate credit does move its sympathy with global markets which are full of such names.
Rate hikes strike in an uncertain world
With materially higher rates now priced by Government Bond markets, the economy is expected to slow rapidly as rate hikes bite, hitting the public, lowering confidence and curtailing discretionary spending. Liquidity and asset quality will become important considerations for portfolios looking to benefit from steep discounts in many quality assets. We do not expect that rates will fall back to anything like the emergency levels we have seen post pandemic, so it feels like the re-birth of credit and default risk could be with us for some time yet as we move to a structurally higher rate environment than in recent years. It is important to acknowledge that the playbook in the last few episodes of a corporate credit seizure (Central Bank rate cuts and Quantitative Easing) will not work under a higher inflation and unstable geopolitical environment. That pivot of policy simply isn't available if inflation remains above Central Bank mandate levels as we would expect for the balance of 2022 due to the global energy shock.
Funds operated by this manager:CC Jamieson Coote Bonds Active Bond Fund (Class A), CC Jamieson Coote Bonds Dynamic Alpha Fund, CC Jamieson Coote Bonds Global Bond Fund (Class A - Hedged), CC Jamieson Coote Bonds Global Bond Fund (Class B - Unhedged)