Credit Risk in 2017 – Better Opportunities Ahead

 

I have mentioned in previous posts that investors were holding more credit risk at the start of 2017 than they have in recent years.  This could reflect many things.
A few likely candidates are: recent credit performance, lack of alternative sources or return, or a forward view that corporate balance sheets remain strong.

ITRAXX Australia – Recent History
Some causes for concern are apparent though.  For one, credit spreads are near the lowest they have been since the Global Financial Crisis.  This is shown below by the ITRAXX Australia index (description here if you are unfamiliar with it) a key market benchmark for Australian credit spreads.

It is interesting to see just how large the move higher in early 2016, bumping the index up about 80 basis points, even though in hind sight the credit risk changes that caused it are not that memorable.  Primarily it was a flow through effect in commodity markets based on China growth fears that created worries or broader Australian growth.  Similar fears or just reversion to the average may lead the index near 110 basis points later in 2017.

Australian Credit Risk is Banking Sector Risk
Corporate borrowing is heavily concentrated in the banking sector.  The Bloomberg AusBond Credit 0+ Yr Index is designed to track Australian dollar credit risk by market weight.  The index membership is 51% financials comprising 48% of the index by market capitalisation.

  • This may be especially important this year as Australian banks face a few credit headwinds.
    It is broadly expected that Australia will receive a sovereign downgrade this year bringing the country in line with US and UK sovereign ratings. It will be difficult for the banks to maintain their own ratings in the face of the sovereign downgrade.
  • Australian banks are currently very well rated compared to their international peers. For example the large US bank, JPMorgan Chase, has an A- rating while the four Australian majors are AA-.
    These ratings are not directly comparable because the regulatory and bond issuance structures between countries are not exactly the same.  But the much larger and more diversified international banks are probably not that much riskier Australian majors.
    Particularly while the Australian capital adequacy regulations are still being adjusted and likely to fall in line with international standards.
  • Finally, Australian banks have their loan books and lending fees concentrated in home loans. According to the RBA March 2017 Bulletin – Development in Banks Funding Costs and Lending Rates housing lending accounts for two thirds of all lending.
    Considering this in light of the RBA’s concerns that “Recent data continued to suggest that there had been a build-up of risks associated with the housing market” expressed in the March 2017 Meeting Minutes, banks are facing significant near-term uncertainty in their primary business.
    Should these factors lead to a reduced credit rating reduction of two notches, to an S &P single A rating, that would result in a roughly 30 basis points spread expansion.  This can be seen in the chart below comparing AA- and A bond spreads in the Australian market.Graph 2 MK

Better Opportunities Ahead
So with the above factors in mind, investors with the capacity to wait to take credit exposure may find that advantageous.  Spreads are historically low and the influential banking sector faces a few near-term headwinds.  If this view is correct then re-evaluating the spreads on offer after a 30 basis point widening seems reasonable.  On the contrary if the RBA or ratings agencies were to give future reassurance on the housing sector or bank ratings the reasons to wait for widening would diminish.

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