Interest Rates

[sydboy007]

There is still plenty of room to move downwards from 2%.


If you are familiar with the Japanese interest rate cycle, you will know that after the rate fell below 2% it never raised above it again, currently sitting at 0.5% I think.

Meanwhile JGBs provided decent returns in the move from 2% to 0.5% (yields down, price up) while everyone thought that the "top is in" for JGBs for like 20 years now.

Japan has historically run a current account surplus and has had the capability to support much of the Govt debt internally.

Australia has no such luxury. I don't know what the lower bound will be here, but we definitely wont be able to get to 0% like the USA or Japan simply because we are not a safe haven currency like the USA nor a surplus capital country like Japan.

The RBA may be able to take the sting out of the some of the first 1% rise in overseas interest rates, but after that it's likely to be passed on in full to debt holders.

Don't forget how fast things moved when the GFC hit. Interest rates the big 4 had to pay to get credit jumped by over 1.5% very rapidly.

How it all will pan out I'm not sure, but I'm enjoying the compression in bond yields with my SMSF bond portfolio providing roughly 14% annual returns over the last 3 financial years. Not sure it can continue on like that, but I bought in for the income stream. Capital growth has been a very welcome bonus.

Bank deposits wil unlikely give you much more than CPI, and to be honest for a guaranteed product I don't think it deserves much more than that. Taking a bit of risk into some decent corporate bonds will get you at least twice CPI and in some cases close to triple that level. Just wish there was some reasonably priced corporate bond funds in Australia.

 

[sinner]

Japan has historically run a current account surplus and has had the capability to support much of the Govt debt internally.

What does the ability to run a current account surplus actually mean? Most people don't understand it at all. Luckily Michael Pettis has written about it extensively to correct many misunderstandings and misconceptions.

http://blog.mpettis.com/2015/06/internal-and-external-balance/

here is just one small snippet of this long article which links to many other articles

A country’s trade surplus (more accurately its current account surplus, which includes things like royalty payments, tourism, returns on investment abroad, and other things, but we will pretend they are the same) is exactly equal to its total savings minus its total investment, which is equal to the amount of savings it exports. This is why we refer to the balance of payments. The total money that ants receive from their trade (current account) surplus is perfectly balanced by the capital account deficit, which is simply the amount of savings they send abroad.

Why save more than you invest?

Countries run trade surpluses, in other words, not because their citizens are hard working ants, but rather because they save more than they invest. Of course ants are supposed to save more than grasshoppers because they are prudently willing to make some sacrifice today in order obtain a better outcome tomorrow, but this means that they also must invest more than grasshoppers because the only way a sacrifice today results in a better outcome tomorrow is if we save part of today’s production and invest it in something that will increase our productivity tomorrow. The natural thriftiness of ants explains why they save more, but it cannot explain why countries save more than they invest, and so run trade surpluses, year after year. There are three reasons that explain most cases of large, persistent trade surpluses.

The first reason is a good one in that it results in higher growth and a better outcome for the world overall. The second two reasons, which are really variations of the same reason, result in lower growth for the world overall.

In the first case, there is a huge investment opportunity abroad, perhaps because a group of foreign ants have identified a great opportunity to increase productivity, and this opportunity persists year after year. The returns on that investment are so much higher than they are at home that ants at home are willing to save more than they naturally would to invest at home.

Because they save more than they invest, they export the excess savings abroad, where it earns an outsized return. Total growth in production for the world, consequently, is higher, and if that increase in production is shared between the ants at home and foreign ants, every one is better off. Notice however that the foreign ants will be importing savings because their investment needs exceed their savings, and so in spite of their hard work and rapidly rising productivity, they will run trade deficits for many years. In the 19th Century England and the United States played these two roles, with excess English savings pouring into the United States to fund growth in history’s most successful emerging market, and while the British ran persistent trade surpluses, and the US ran persistent trade deficits, both countries got richer.

The second reason a country might save more than it invests is because of high levels of income inequality. Rich people usually save more of their income than ordinary people, so that the more they keep of the total amount of goods and services produced by hard working ants, the higher that country’s savings rate and the lower its consumption rate. Because lower consumption discourages businesses from building new factories or otherwise expanding production, higher savings often come with lower investment, and so countries with highly unequal income distribution tend to run large trade surpluses.

The other reason has to do with the share that households receive of everything they produced. A country’s total production is divided between households, businesses, and the government. Although governments do make purchases that we can classify as consumption, almost all consumption comes from households. This matters, because in countries in which households are allowed to keep a very large share of what they produce, whether they are as thrifty as ants or as spendthrift as grasshoppers, their total consumption will be a high share of total GDP, and total savings a low share. If their high consumption encourages businesses to open new factories, low savings and high investment might even lead them to run temporary trade deficits, although only until the factories begin to produce.

But if households retain a low share of everything they produce, with governments and businesses getting the rest, then again, whether they are as thrifty as ants or as spendthrift as grasshoppers, their total consumption will be a low share of total GDP, and the country’s total savings, which is equal to GDP minus consumption, will be a high share. Once again if low consumption actually causes investment to drop, they will run large trade surpluses. Notice however, that the country has a high savings rate not because ants have saved a lot of their earnings. It has a high savings rate because businesses and governments are able to save the money that was not given to households.

Australia has no such luxury. I don't know what the lower bound will be here, but we definitely wont be able to get to 0% like the USA or Japan simply because we are not a safe haven currency like the USA nor a surplus capital country like Japan.

Demand for AU gov bonds has been high from Central Banks reweighting away from USD/EUR/JPY. High enough that while the AUDUSD was above 1, the RBA was actually selling bonds directly to other CBs off market to avoid their demand supporting the price. If those off market transactions were to come back on to the direct market, you can bet that the AUDUSD would be a lot higher than where it is today.

The RBA may be able to take the sting out of the some of the first 1% rise in overseas interest rates, but after that it's likely to be passed on in full to debt holders.

Don't forget how fast things moved when the GFC hit. Interest rates the big 4 had to pay to get credit jumped by over 1.5% very rapidly.

I haven't forgotten. But you are conflating two things here. First, you have implicitly assumed that rates will rise any time soon, by an amount that would entail massive reductions in Central Bank balance sheets (i.e. unlikely). Second you are conflating this assumed rate hike with spiking corporate rates during a credit crunch where Government rates declined to all time lows.

How it all will pan out I'm not sure, but I'm enjoying the compression in bond yields with my SMSF bond portfolio providing roughly 14% annual returns over the last 3 financial years. Not sure it can continue on like that, but I bought in for the income stream. Capital growth has been a very welcome bonus.

Nobody knows for sure, obviously, but the good thing about AAA Government bonds is that you can forecast their return under the assumption they are default free (i.e. may lose real but not nominal value). So we can forecast the benchmark rate for 10-30Y out from now, and compare it to the returns we might receive from other investments (adjusted by volatility if necessary) of the same duration to decide where to invest. i.e. maybe 2% p.a. doesn't sound like an awesome investment, but then again if your 10y annualised forecast for equities is <2%, after considering the volatility you may decide actually 2% bonds don't sound so bad.

(as an example)
http://hussmanfunds.com/wmc/wmc150608.htm

We estimate that from current valuations, the S&P 500 will underperform Treasury bonds by more than 2% annually over the coming decade. We’ve never observed a similar level of stock vs. bond valuations without stocks actually underperforming bonds over the subsequent 10-year period. Next, look at bear market lows such as 2009, 2002, 1990, 1987, 1982, 1978, and 1974, and recognize that the completion of every market cycle in history has provided better investment opportunities, both in absolute terms, and relative to bonds, than are presently available.

 

[sydboy007]

What does the ability to run a current account surplus actually mean? Most people don't understand it at all. Luckily Michael Pettis has written about it extensively to correct many misunderstandings and misconceptions.

http://blog.mpettis.com/2015/06/internal-and-external-balance/

here is just one small snippet of this long article which links to many other articles

Demand for AU gov bonds has been high from Central Banks reweighting away from USD/EUR/JPY. High enough that while the AUDUSD was above 1, the RBA was actually selling bonds directly to other CBs off market to avoid their demand supporting the price. If those off market transactions were to come back on to the direct market, you can bet that the AUDUSD would be a lot higher than where it is today.

I haven't forgotten. But you are conflating two things here. First, you have implicitly assumed that rates will rise any time soon, by an amount that would entail massive reductions in Central Bank balance sheets (i.e. unlikely). Second you are conflating this assumed rate hike with spiking corporate rates during a credit crunch where Government rates declined to all time lows.

Nobody knows for sure, obviously, but the good thing about AAA Government bonds is that you can forecast their return under the assumption they are default free (i.e. may lose real but not nominal value). So we can forecast the benchmark rate for 10-30Y out from now, and compare it to the returns we might receive from other investments (adjusted by volatility if necessary) of the same duration to decide where to invest. i.e. maybe 2% p.a. doesn't sound like an awesome investment, but then again if your 10y annualised forecast for equities is <2%, after considering the volatility you may decide actually 2% bonds don't sound so bad.

(as an example)
http://hussmanfunds.com/wmc/wmc150608.htm

Propping up Govt debt is much easier when you have a trade surplus. Japan is still one of the worlds largest creditors.

Aus GBs are unlikely to be AAA for much longer. 30% gross debt appears to be the line in the sand. The continued unwinding of the ToT will see resource profits continue to decline. The budget forecasts are already wrong on CAPEX and I/O and coal prices. I'd expect the AAA to be in danger before the next election. That's my base belief. If the car companies shut early or the housing building boom ends early due to falling pop growth then things will get ugly a lot sooner.

Mortgage and other private sector interest rates are set more by the cost of overseas bond markets than they are by the official cash rate. I'm not predicting the RBA to raise rates, it's going to have to lower them, but depending on how grexit and the china hard landing goes the aussie banks may have to pay more for credit. They're back to pre GFC levels of nearly 60% of funds from overseas. Overseas funding is currently cheap(ish) but there's no guarantee that will continue, especially since the banks have started moving back to getting shorter terms.

2% Govt bonds sounds a raw prawn to me. Why not get into some rated corporate bonds and get 4-5% for not much more risk? Some ILBs are still offering cash flow of ~3.5%. Not bad when you're income keeps pace with inflation.

 

[sinner]

I do acknowledge that a lot of the concerns you listed as risks to the AAA do also concern me more generally too.

2% Govt bonds sounds a raw prawn to me. Why not get into some rated corporate bonds and get 4-5% for not much more risk? Some ILBs are still offering cash flow of ~3.5%. Not bad when you're income keeps pace with inflation.

It was only an example number, not a real one (but for reference the current yield on Aus 10y is ~2.8% and 20y is ~3.4%). Investment choices like Gov vs Corp should only be made by individual investors after due diligence and personal risk evaluation, definitely not by blindly reaching for yield.

I am not huge on gov bonds personally (I prefer gold as a long term savings vehicle), but I do hold some in both super and personal accounts to reduce overall portfolio correlation (which is not a feature corporate bonds provide) and I seem to assign a lower probability to interest rate hikes than most.

 

[McLovin]

2% Govt bonds sounds a raw prawn to me. Why not get into some rated corporate bonds and get 4-5% for not much more risk? Some ILBs are still offering cash flow of ~3.5%. Not bad when you're income keeps pace with inflation.

It's interesting that you can be so negative on pretty much everything relating to the Australian economy, but still think Australian corporate bonds at 4-5% represent good value.

 

[qldfrog]

It's interesting that you can be so negative on pretty much everything relating to the Australian economy, but still think Australian corporate bonds at 4-5% represent good value.

I share sydneyboy view: if i can get 3% above inflation: I sign today;
I was actually wondering where i could get that!

 

[McLovin]

I share sydneyboy view: if i can get 3% above inflation: I sign today;
I was actually wondering where i could get that!

Here you go...

http://thewire.blob.core.windows.ne...e/fiig-rate-sheet/fiigratesheet.pdf?sfvrsn=26

 

[sydboy007]

It's interesting that you can be so negative on pretty much everything relating to the Australian economy, but still think Australian corporate bonds at 4-5% represent good value.

Value in a sense is relative, not absolute.

Some corporate bonds still represent good value compared to Govt bonds or much of the share market.

What do you believe would be a realistic rate of return going forward? 5% with relatively low risk from a corporate bond issued by a company that has regulated assets seems a decent compromise in the current low rate low growth environment, especuially if there's further yield compression as I suspect there will be.

My pessimism is paying off so far. Bonds are working well for me and moving funds out of AUD assets is also paying off. I don't se much sunshine for the aussie economy over the next few years. Lots of job losses coming from the resource CAPEX cliff and closing of the car industry. I honestly don't know where the jobs to replace them will come from. Tourism certainly wont fill the gap.

 

[sydboy007]

Here you go...

http://thewire.blob.core.windows.ne...e/fiig-rate-sheet/fiigratesheet.pdf?sfvrsn=26

i use FIGG. Thumbs up for making access to bonds easier. Wish they'd launch a corp bond ETF.

 

[Junior]

i use FIGG. Thumbs up for making access to bonds easier. Wish they'd launch a corp bond ETF.

These guys launched a couple of months ago, individual exchange traded corporate bonds: http://www.xtbs.com.au/available-xtbs

 

[McLovin]

Value in a sense is relative, not absolute.

When comparing a basket of bonds/shares/real esate you can get some idea on relative value, but you need to be adequately compensated for risk on an absolute basis. When I look down that list and see Mackay Sugar with ytm of 5.5% on an unrated, unsecured issue I have a hard time accepting risk is being compensated.

What do you believe would be a realistic rate of return going forward? 5% with relatively low risk from a corporate bond issued by a company that has regulated assets seems a decent compromise in the current low rate low growth environment, especuially if there's further yield compression as I suspect there will be.

For bonds? I have nfi. I assume you're talking about Sydney Airport? A BBB rated company. What does BBB mean?

BBB: An obligor rated 'BBB' has adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

(My bolding)

So how does that fit in with your assesment of where the economy is heading? If the scenarios that you post here actually come to fruition what are the chances that SYD cannot make its payments? I'd also point out that the next rating below BBB is junk status.

 

[sinner]

especuially if there's further yield compression as I suspect there will be.

Wait..

So you believe we are essentially at ZIRP, and you're skeptical of further declines in rates since we aren't a reserve currency or a capital account surplus, and you think our economy is screwed and you think we won't get to keep our AAA...

But you also suspect there will be further yield compression?



How does that work?

 

[sydboy007]

Wait..

So you believe we are essentially at ZIRP, and you're skeptical of further declines in rates since we aren't a reserve currency or a capital account surplus, and you think our economy is screwed and you think we won't get to keep our AAA...

But you also suspect there will be further yield compression?



How does that work?

Can't current corporate bond yields compress further?

Can't new loans banks need to get to roll over expiring loans increase in costs as they did during the GFC.

The bond / credit markets are quite big. Remember when the banks didn't pass on the full RBA rate cuts? What happens when the cash rate is 1% and bank cds continue to increase? How low can the cash rate go? In a risk off environment what do you think that will do to Aussie Govt bonds? Outside of Central banks who'd want to buy Aussie Govt bonds now with the reasonable expectation of further AUD falls. is it worth the risk of loosing 10%+ on the currency for maybe an extra 2% yield?

Just for interest sake what's your views on where interest rates are going? Do you think the AAA rating is safe? How low will the market lets interest rates go in Australia?

 

[sydboy007]

When comparing a basket of bonds/shares/real esate you can get some idea on relative value, but you need to be adequately compensated for risk on an absolute basis. When I look down that list and see Mackay Sugar with ytm of 5.5% on an unrated, unsecured issue I have a hard time accepting risk is being compensated.



For bonds? I have nfi. I assume you're talking about Sydney Airport? A BBB rated company. What does BBB mean?



(My bolding)

So how does that fit in with your assesment of where the economy is heading? If the scenarios that you post here actually come to fruition what are the chances that SYD cannot make its payments? I'd also point out that the next rating below BBB is junk status.

I'd not touch mackay sugar with a barge pole. Others might

SYD AP - you'd have to decide on how likely they'd not be able to make an interest payment. Considering there's no alternative to air travel in Australia there wont be too big a reduction in passenger numbers, and with the falling AUD we're seeing a decent uptick in inbound tourism. International tourists spend up more, and retail is a big money spinner for the airport, along with parking.

cash converters could be a decent bond buy at 6.7%. pawn brokers tend to do well in difficult times. Plenary fixed with YTM of 6.24% would also be reasonable as they receive payment from the Govt. Pickings are certainly slimmer than 6 months ago.

personally I don't think risk is being adequately compensated for in pretty much all asset classes. Bank deposits barely compensate for inflation, a lot of bonds don't compensate enough, and shares in general are over valued, while property yielding a net 3% or less doesn't seem too hot either.

maybe buying some gold jewlergy is the safer way forward

 

[craft]

cash converters could be a decent bond buy at 6.7%. pawn brokers tend to do well in difficult times.

Seriously? There might be more demand in a recession but there will also be a lot more defaults.

At least 75% of earnings are from the most sub of sub prime lending. The balance sheet has nothing of substance except a bit of inventory which is second hand crap and the loan book. IF CCV's debt doesn't become priced as distressed in a recession I would be amazed. 6.7% is rose coloured ridiculous.

 

[qldfrog]

Thanks for the various inputs, FIIG a resource I am happy to know now.

 

[sydboy007]

Seriously? There might be more demand in a recession but there will also be a lot more defaults.

At least 75% of earnings are from the most sub of sub prime lending. The balance sheet has nothing of substance except a bit of inventory which is second hand crap and the loan book. IF CCV's debt doesn't become priced as distressed in a recession I would be amazed. 6.7% is rose coloured ridiculous.

You could be right. In the day of ebay and gumtree do we still need pawn brokers? Still, they've been around with the rise of online competitors so there's some market demand for their services.

 

[odds-on]

I found the attached article a good read, so thought I would share with ASF.

http://aswathdamodaran.blogspot.co.uk/2015/04/dealing-with-low-interest-rates.html

Not really anything we can do about low interest rates other than accept "it is what it is" and make the appropriate modifications to any valuations. I think we will be in a low growth economic environment for many years...

 

[craft]

You could be right. In the day of ebay and gumtree do we still need pawn brokers? Still, they've been around with the rise of online competitors so there's some market demand for their services.

You still seem to be seeing CCV just as a pawn broker – That seems to me like describing a chemist by the retail business at the front of their shop and ignoring the prescription drug business.



This seemingly unawareness of the true dynamics of the business and the risks involved is what makes me shudder at your line.

cash converters could be a decent bond buy at 6.7%. pawn brokers tend to do well in difficult times. :

It seems symptomatic to me of the chase for yield by people who in most cases have no idea of the extra risks they are taking to get that yield. When risk gets under-priced things become more risky. Financial suppression across the entire capital market line is pushing the risk adverse and uneducated in particular niches to inadvertently become the ultimate risk takers and that makes things risky for all of us.

I asume in making your call about CCV debt you would be able to at least answer these basic questions:

What % of CCV profit comes from subprime lending?
What is the interest rate CCV charge on that lending? Is that under legislative risk? Are they pushing the intent of current rate caps with various fees?
What is the % of bad loans written off against those loans. What is CCV's earnings sensitivity to default rates
What is the history of default performance of these loans in a down turn?
Are the bonds secured?
Does CCV have any other borrowings - do those other borrowings have a priority security.
What is the term of those other borrowings - Can CCV stay in business if those other borrowing are withdrawn or not renewed. How likely is renewal of those other facilities in a recession?
What fixed lease commitments do CCV have? Are the bond repayments superior to these claims?
How much in tangible assets does CCV have on the balance sheet. How much would the inventory be worth in a liquidation? How much of the PPE is lease improvements or assets without other uses?

 

[sinner]

Can't current corporate bond yields compress further?

Just to clarify, when you say "compression" I assume you are referring to yields going down.

The answer to which of course is: yes, no, anything is possible. But given your concerns about the economy it doesn't seem congruent to bet on corporate yields dropping.

Can't new loans banks need to get to roll over expiring loans increase in costs as they did during the GFC.

This would be the opposite of yield compression...which is makes what you're saying kind of confusing.

The bond / credit markets are quite big. Remember when the banks didn't pass on the full RBA rate cuts?

You are once again conflating multiple things here.

When you say "didn't pass on the full RBA rate cuts", I assume (since you don't specify at all) that you are referring to passing on rate cuts to mortgagees? Yes, I remember this, but it was temporary, and more importantly: so what? Not passing on rate cuts is the banks trying to protect margins. Rate cuts were also "not passed on" to savers, as the big 4 competed for deposits as a source of funding. Again, not sure what these questions have to do with anything...

What happens when the cash rate is 1% and bank cds continue to increase? How low can the cash rate go?

If this is some kind of rhetoric where you know the answer to this question, perhaps it would have been better if you had simply and clearly stated what you think is going to happen. I am not sure why you are asking me a hypothetical when you seem to believe the cash rate could never achieve 1% in the first place.

How low can the cash rate go? In real terms it can go quite negative, and in nominal terms it can probably go quite close to zero, especially if the forecast for long term economic growth is low.

In a risk off environment what do you think that will do to Aussie Govt bonds?

Anyone can go to the RBA website, download some data (e.g. construct yourself a Gov/BBB yield spread) and find out what happens to Aus Gov bonds during risk off environments. Hint: they generally do not go down. Perhaps you have never experienced a yield curve inversion where investors pile into long duration Govt debt.

Again, if this is some sort of hypothetical where you're assuming everyone knows the answer to this rhetoric, maybe better to just come out and say whatever it is you're thinking?

Outside of Central banks who'd want to buy Aussie Govt bonds now with the reasonable expectation of further AUD falls. is it worth the risk of loosing 10%+ on the currency for maybe an extra 2% yield?

Uh, you realise that for bonds to be issued, someone has to buy them, right? So outside of Central Banks, it's probably safe to assume everyone who was issued Aussie Govt bonds wanted to buy them...hundreds of millions/billions in AUM...

When did foreign exchange come into this? So now the thesis is that Aus Govs suck because of the AUDUSD?! I guess for experts at predicting where the interest rate will go, predicting foreign exchange movements are also a simple task.

Just for interest sake what's your views on where interest rates are going? Do you think the AAA rating is safe? How low will the market lets interest rates go in Australia?

As I have already stated, I assign a relatively low probability of rate hikes within the next 12 months compared to most here, and I feel like there is plenty of room for yields to decline further.

Do I think the AAA rating is safe? I don't know why my opinion counts, since I am no expert in analysing the balance sheets of countries. But the market yield (representing the aggregate marginal opinion of an entire market of experts) for Aus 10y is 2.93%, while the US 10y is 2.38%...so you can see that investors are not demanding a significant risk premium to fund AU vs US. Perhaps you are smarter than the market yield.