It has been some years since we have felt the need to do a mid- week market update, however brief it might be, but this is shaping up to be an extraordinary week. The global market reaction to the increase in the probability of a recession following last week’s US economic data looks irrational given our view (expressed in our latest Weekly Update) that the US data was impacted by weather events in July and so is unreliable. This is not to say that a sell-off is not warranted to better reflect the risks of a recession at some point over the next 12 months in the US, because an asset bubble had clearly formed in parts of the US equity market – the Mag 7. On its own, the bursting of this bubble will do no long-term harm to the economy because there is little systemic risk from such a fall in equity value. Over time these productive companies will continue to build earnings and pay dividends so that, at some point again, the share prices will have recovered to the recent peaks. It may take some time because the earnings multiples at their heights – and even still now- are extreme.
The bursting of an asset bubble can trigger some systemic risk where there is a high degree of leverage. The 12.4% fall in the Nikkei index (Japan) is likely to have due to the Yen Carry trade whereby funds, were borrowed in Japan to be invested offshore, being unwound rapidly (The Yen carry trade may be as much as $4 trillion dollars). The equity sell-off in Japan is therefore not about the fears of a recession in Japan (yet) but that the unwinding of the Yen Carry trade will see the Yen strengthen further and it has been the Yen weakness that has been driving the Japanese economy over the past 18 months.
The Preferred Income Fund is a debt fund that holds only securities issued in Australian dollars. While it can hold a portion of debt securities that have some equity characteristics, it does not need to give them a significant weighting in the portfolio in order to achieve the stated target return of 90-day BBSW plus 350bps. In fact, at the moment the portfolio contains less than 1% bank Tier1 hybrids due to a lack of value at current margins. The PIF is not a high yield and illiquid private credit fund – that will get smashed in a risk sell off. At least 70% of the portfolio is in debt issued by APRA regulated Australian Banks and Insurers in order to provide a high level of liquidity even in stressful market conditions.
We have been patiently waiting for this sell off event – our weekly and monthly updates have repeatedly forecast that the equity market was too high relative to valuation, inflation remains a high risk, and credit spreads are too tight relative to the risk of a recession. The PIF has a credit spread duration of 1.69 (a typical credit fund has a like for like reading around 4.0). We have seen no need to chase a higher portfolio yield by increasing the credit duration of the fund.
Note – we do not accept performance fees, so we are acting to reduce risk towards the required return of 90-day BBSW + 350 bps at all times.
This equity market sell off should – with a small lag – push all credit spreads wider. Rationally, the move in credit spreads will be widest for high yield credit opportunities (property developer debt and land banks that are geared without actual income) and securities ranked lower in an issuer’s capital structure. In a typical Australian bank then, we would expect spreads to widen the least for Covered Bonds followed by Senior Bond, but then there is a risk of a significant shift wider by Tier 2 and Tier 1 Securities where margins were last week very tight by historical standards (and not reflective of the recession risk). Again, the PIF portfolio has been positioned with an expectation of this margin widening occurring at some point. Profits have been taken on Tier 2 and Tier 1 Securities over the past 5 months and the funds rolled into Senior Bonds.
The PIF performance over the next 12 months will be underwritten by the current running yield of 6.83% (effective return of 7.01%) and the YTM of 8.91%.
If you have any questions during this volatile period about any of our funds or specific bonds, issuers or products, please do not hesitate to contact anyone of the Arculus team directly.
