Shifting Risk Preferences – Part 2

 

We continue our thoughts and observations on fixed income in your investment portfolio in our 2nd Blog for this series.

As discussed in Shifting Risk Preferences – Part 1, two key themes emerged in investors bond holdings in 2016 when comparing it to historic data since 2013.

  1. Though interest rates stayed in a similar range in 2015 and 2016 investors appear to be shying away from fixed coupons perhaps believing that the interest rate cycle has turned.
  2. While small, there is a consistent trend in increasing credit exposure that shows up across the various metrics explored.

The metrics explored in Part 1 – coupon type, capital structure ranking, and credit ratings – all appeared consistent with investors avoiding interest rate risk while trying to preserve returns by accepting more credit risk.  

  • By coupon type, investors were moving into floating coupons;
  • By capital structure ranking, investors shifted to subordinated debt; and
  • By credit rating, investors shifted out of AAA with more unrated holdings.

Continuing this analysis we will consider investor holdings by issuer type, maturity, and country.

Issuer Type

The data shows shrinking government holdings consistent with the fall in AAA credit rated bonds.  The fall is one of the larger shifts from 40% government debt in 2014 to just under 20% at the end of 2016.  There could be several drivers for this:

  1. Government interest rates are near historic lows;
  2. The market no longer expects cash rates to fall as the mining recovery in late 2016 continues to support economic growth, and;
  3. Both domestic and foreign banks continue raising capital in the Australian debt market.

Of these the second is probably the strongest driver as government debt has maturities out to 30 years leaving investors facing substantial price falls if interest rates do indeed begin to rise.  This is also consistent with the US continuing to hike interest rates as economic growth there appears to have accelerated also.

Maturity

Above it is apparent that investors are holding more long-maturity debt.  This is slightly inconsistent with the shift away from interest rate risk and government debt. A likely explanation is that this data only captures a bond’s final maturity, ignoring potential earlier call dates, effectively overstating the interest rate risk (also referred to as duration).

Both banks and corporates have been issued more long-dated structured debt, both to take advantage of low interest rates but also because the Global Financial Crisis  (GFC) has made management and regulators intentionally shift capital structures towards more equity-like obligations.  

The previous chart showed government holdings shrinking relative to corporate and bank debt indicating the amount of credit risk being held by investors has increased substantially – as bond payments depend on private sector earnings for a longer investment horizon.

Country

In looking at investors country preferences, a notable trend is an increased European holdings.  The rolling European debt crisis, centred on Greece, began in 2010 and Australian investors have perhaps gotten used to the somewhat regular flare ups of negative headlines.  European banks also continue to pay a premium to Australian bank yields because of the perceived higher risk while those banks are still also likely to benefit from the support of their home governments.

It is also worth mentioning that the absence of meaningful holdings in Asian countries is surprising given the close trading relationship of Australia with that region compared to the United States or Europe.

What to watch for in 2017
While the changes on each chart are quite gradual the combined drop in government holdings, extended maturity profile, lower credit rating, and lower place in the capital structure could reflect a substantial exposure change in the credit risk held.  There may be particular exposure to watch for in the European banking sector.

The drop in government holdings and preference for floating rates also might leave investors missing out on capital gains should interest rates move down as economic growth moderates.  

Somewhat surprisingly if interest rates head higher, which means bond prices are lower, this aggregate portfolio is well positioned and likely to tolerate the move quite well.

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