Kreston marker update week ending Friday 27th November 2009

Kreston ANZ

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News

News 2009

Kreston Dormers

Kreston Dormers Financial Services Pty Ltd

Please find below and attached our 'Weekly Market Update'.

We are continuing to get feedback and suggestions for improvement on the report, so if you have any suggestions please let us know

If you would like to discuss this email in more detail, please contact your financial adviser, Mark Johnson or Nick Pike on 1800 064 959.

Market Summary

The market fell by over 2% on Friday morning on the back of Dubai’s debt deferral proposal. The S&P/ASX 200 fell -1.8% for the week led by Property -5.4% weaker and the Banks down -3.4%.

	Friday	Week	%
All Ordinaries	4,620	-84	-1.8
S&P / ASX 200	4,599	-84	-1.8
Property Index	849	-48	-5.4
Utilities Index	4,161	-38	-0.9
Financials Index	4,490	-158	-3.4
Materials Index	12,042	-10	-0.1
Energy Index	15,544	-273	-1.7

Overseas, the US S&P 500 rose 1.4% up until Wednesday night. The US was closed for Thanksgiving Thursday night and the futures indicate the market will be 2.0% weaker on Friday open reflecting the Dubai news. UK’s FTSE was 1.4% weaker as its banks were hit by Thursday’s selling and similar trends in Asia saw the Nikkei down -2.9% and Hong Kong’s Hang Seng decline -1.9%.

Overseas the big news was the debt deferral proposal from Dubai which caused Friday’s fall on the markets. In Australia, the RBA and BHP’s CEO expressed confidence in the Australian economy. Our feature section reviews Australian bank hybrids which have been the subject of media reports of late.

Overseas News

The Dubai government has proposed a delay of debt repayments after property developer and investment company Dubai World requested a ‘standstill agreement’ with its creditors.

Dubai World owes $59 billion of Dubai’s $80 billion debt and has assets including stakes in MGM Mirage and Standard Chartered Bank. The debt is material enough to the Dubai economy for the government to intervene and propose the delay.

Dubai is one of the seven emirates that make up the United Arab Emirates (UAE) in the Gulf region. Abu Dhabi is the strongest financially as it holds 8% of the world’s oil reserves and they have already begun supporting Dubai by buying $5 billion in bonds yesterday.

Dubai has been running a ‘build it and they will come’ approach to developing their economy. There have been major developments such as a palm tree shaped island and the world’s tallest building proposed (which usually means that a country or company is heading toward a downturn).

As you would expect, the largest creditors of the company are other UAE banks although Bloomberg reported that a number of European banks such as HSBC, Barclays, Lloyds and Royal Bank of Scotland have an unspecified exposure. Shares in these European banks were down heavily overnight.

Credit markets up to this point have assumed that Abu Dhabi would step in if required. However, Abu Dhabi has made it clear that they are not going to bail out Dubai World. We expect that Abu Dhabi will not allow Dubai itself to default as this would destabilise the country politically.

As a further undercurrent, apparently there has been considerable pressure from Abu Dhabi and the US on Dubai to fall in line with their trade polices with Iran (Iran is a major Dubai trading partner). There is no doubt Abu Dhabi will be using the crisis as a lever and will make Dubai absorb considerable pain but we expect at some point they will back Dubai.

We expect that Dubai will enforce sale of Dubai World offshore assets. There will also be pressure on Dubai to sell other assets such as the global portfolio of port operators owned by company DP World.

It will take some weeks for the markets to digest this development and investors will be looking for confirmation that Abu Dhabi will back Dubai.

Individual Australian companies likely to be impacted include Worley Parsons, Leightons and Hastie Group.

In the US, existing home sales which comprise 90% of the home sales rose 10% in October and inventories of unsold homes has now dropped to 7 months compared to 8 months in September. New home sales increased by a greater than expected 5% from October 2008. Increased sales are more likely to support rising home prices.

The above is in contrast to an unexpected decline of 10.6% in US housing starts we reported last week.

The above numbers reflect home buyer purchasing decisions conditions taken some months previously. Nevertheless the US housing market is showing early signs of recovering and we continue to monitor trends as it is an important requirement for the health of the US economy.

Further news from the US is that the US Federal Reserve (‘The Fed’) has asked nine of the US banks that received TARP ‘bailout’ funds to submit plans for repaying the funds. This will be driven by the improving financial position of the banks and the government’s need to reign in the budget deficit.

In Europe, a survey of purchasing managers in the manufacturing and services sectors rose from 53 to 53.7 in October. A reading above 50 indicates the economies are expanding.

An interesting statistic this week was that if you missed the top 20 days on China’s share market between May 1999 and May 2009, your return would fall from 19% p.a. to -1.4% p.a. (China Investor Weekly June 2009). More mature markets such as ours tend not to be as volatile but the lesson that gains and losses are made in very few days holds true in all markets.

Australian News

Deputy Governor, of the Reserve Bank of Australia Ric Battellino predicted this week that Australia’s economy would continue to grow at least over the next few years. He singled out growth in mining investment despite being at record levels and the recent strength in construction activity.

BHP, CEO Marius Kloppers, stated that while demand for commodities was increasing outside China as companies began to rebuild inventories, he was of the view that restocking of Chinese inventories was substantially complete. In what was possibly a word of caution he went on to say that he is continued to be surprised by the ‘resilience of the Chinese steel sector’. Kloppers went on to reiterate his view that growth of the global economy would be more muted than in past recoveries.

On the commercial property front, the AFR reported a number of CEO’s predicting that commercial property values were stabilizing. Given the low number of transactions to date, it is still too early to call a turnaround but given prices received in recent transactions, it is conceivable that we are in the early stages of commercial property prices bottoming.

Toll Holdings (TOL) announced it had won a $1 billion, 5 year contract from the Department of Defence for relocation services. 50% of the contract will be new business.

Energy company Woodside (WPL) announced that its Pluto LNG project off the WA coast was likely to cost up to $1.1 billion more than the previous budget of $11.2 billion. This immediately reignited conjecture that the company would need to raise more capital as further borrowing might impact its credit rating. Also doing the rounds again was conjecture that BHP might buy out Shell’s 34.3% of Woodside although Shell has stated it is comfortable with its stake in Woodside.

Wesfarmers (WES) held a Coles investor day and announced that the store renewal program and its new ordering system were on track. Coles plan 50 store renewals by the end of the financial year 2010.

Hybrids & the Ratings Agencies

We have been receiving a number of queries from clients relating to newspaper reports that ratings agency Moody’s is proposing to downgrade hybrid ratings. It should be noted that the issue relates to bank hybrids only.

The Moody’s actions should not be confused with the Standard and Poor’s (S&P) announcement that they will no longer allow their ratings to be used for retail investors.

The major ratings agencies Moody’s, Standard and Poors (S&P) and Fitch are employed by companies to rate the credit worthiness (strength) of the company or a particular product (e.g. a hybrid). The intention is to provide investors with ‘independent’ comfort in the company or security.

Below we have described the features of hybrids and then assess the impact of the Moody’s report on bank hybrids.

What are hybrids ?

‘Hybrids’ is a term used for a range of interest bearing securities :

  •  Income Notes and Perpetual Securities : interest payments are based on a margin over the 90 day bank bill rate. For example, the NABHA pays a margin of 1.25% over the bank bill rate. They are ‘perpetual’ in that there is no maturity date (i.e. a date they must repay investors).

  •  Reset Preference Securities : similar to the above except they may have a fixed or variable (floating) interest rate. They specify a date that the issuer may either repay the investment or increase the margin or interest rate. For example, IAG’s IANG security has a ‘step up’ in interest rate from 1.2% to 4.0% by 31 March 2010 if not repaid.

  •  Mandatory Convertible Preference Shares : Can be fixed or variable but a key difference to other hybrids is that there is a mandatory maturity date. Generally there is an option for the company to ‘repay’ the investor by cash or by shares. Most recent bank issues have been of this type. For example the recent ANZ issue which has a mandatory maturity date of 7 years and pays a margin of 3.1% above the 90 day bank bill rate. Other examples with different margins and maturity dates are CBAPA, CBAPB, ANZPB, WBCPA, WBCPB and SUNPB.

  •  Step Up Preference Shares : These preference shares are similar to the Reset Preference Securities in that they generally have a date where the margin is increased or the securities are repaid. An example is the CBA PERLS III (PCAPA) which has a reset date of 6 April 2016.

How do we assess the risk and returns of the hybrids ?

  •  The strength or credit worthiness of the issuer. At present we are only recommending (for new investments) those that are issued by one of the Big 4 banks. These banks are AA rated which places all four in the top 8 banks in the world.

  •  Fixed or Variable Interest Rates ? As the Reserve Bank is expected to continue raising interest rates we have taken the view that securities that take advantage of rising interest rates are more attractive. Most hybrids have a variable interest component (tied to the 90 day bank bill rate) and a fixed interest component (the margin above the 90 day bank bill rate).

  •  Yield and Yield to Maturity. Yields differ by the size of the margin above the bank bill rate (yield = bank bill rate plus a margin). Some banks include franking credits as part of the yield. The Yield to Maturity takes into account the amount of capital gain (or loss) you will experience between the price you pay today and the amount you receive on maturity. For example, the Commonwealth Bank CBAPB can be purchased for $188.00 and at maturity in 3 years you will be paid $200.00 in cash or equivalent in shares. While it is only paying 1.05% above the bank bill rate, once the capital gain ($12.00) is added to the current gross interest ($5.0862%) the Yield to Maturity becomes 7.65% p.a.

  •  Maturity Date. Having a maturity date provides some ‘certainty’ to an investor that they will be repaid. Consequently, the risk is lower for those hybrids with a Mandatory Maturity Date. As a general rule the shorter the term to maturity the less the risk.

  •  Ranking of investors should the company be wound up. Generally hybrids rank ahead of ordinary shareholders but behind deposits and other debt securities such as company bonds. In that sense they are more like a share than a bond. Also there may be restrictions on the company paying distributions should it experience difficulties. For example the regulator may require a bank not to pay a distribution if it was making losses. These are the issues Moody’s have raised that we discuss below.

What is Moody’s proposing ?

Moody’s have announced that they are changing the way they rate bank hybrids. This is likely to result in the hybrids of the Big 4 banks being downgraded 4 notches to Baa1 from Aa3. The new rating is still ‘investment grade’ which alleviates some concerns put forward in the media that institutions will sell their holdings as they do not meet investment mandates (i.e. a fund manager may only be able invest in investment grade securities).

Moody’s rationale is based on :

  •  During the banking crisis in Europe, governments did not provide systemic support for the hybrids. That is, there were no government guarantees offered to hybrid holders. Furthermore a European bank suspended distributions and investors in UK bank Northern Rock and two Danish banks suffered hybrid losses. It is surprising that Moody’s previously assumed that the government or regulator would provide support to hybrids in a banking crisis.

  •  Non-cumulative distributions must not exceed the preceding 12 months after tax profit although banks can apply to regulators for an exemption. This is not a new requirement.

So what is the risk of Australian Banks not paying a distribution ?

In a recent ‘Hybrid Weekly’ report (24th November 2009), Bell Potter Securities pointed out that only two recent events could have resulted in the distribution test potentially being instituted. Firstly, in 2001 NAB wrote off $3.6 billion due to accounting errors related to their Homeside investment in the US. Nevertheless this write-off would still not have pushed NAB into a loss and in that year the sale of Michigan National resulted in NAB reporting a $2 billion profit. NAB continued paying dividends.

Another example was in 2008 when IAG wrote down their UK insurance assets. In response IAG raised capital to repair its balance sheet and continued paying dividends.

Going back further, during Australia’s own banking crisis in 1991/92 Westpac and ANZ were in trouble on the back of commercial property loans going bad. Despite their parlous state at the time dividends were paid.

In all of these cases, as ordinary bank dividends cannot be paid unless hybrid distributions are paid, the hybrid distributions would have continued.

Given the current well capitalised position of the Big 4 banks it would require a very significant and adverse event for one of the Big 4 bank’s hybrids to miss a distribution.

In that case, we regard Moody’s change to their hybrid rating as overdone, at least in the Australian context.

How do Standard and Poor’s rate hybrids

S&P rates hybrids 2 notches below that of the bank rating bringing the Big 4 hybrid ratings currently to A+ (described as Upper Medium Grade : strong). Their ratings approach could reduce this rating if for example, a bank incurred losses or its financial position materially deteriorated, or there has been specific government intervention to support a financial institution.

Using the S&P approach it would be difficult to envisage a downgrade to Australian Bank hybrids at this point to the extent of those proposed at Moody’s.

Is Moody’s or S&P approach more appropriate ?

Our Big 4 banks have remained profitable and in a strong capital position. None of the Big 4 banks have been downgraded and senior debt similarly has been unaffected.

In that case, in the Australian context the S&P approach would appear more appropriate.

Also, given the history of dividend payments by the Big 4 in Australia it is difficult to justify the rerating by Moody’s on the basis of an increased risk of distributions not being paid.

Other analysts support this view. Of the recent reports on hybrids I have read of late, Citigroup continue to rate all of the Big 4 hybrids as Low risk (and incidentally ‘undervalued’). Similarly, Bell Potters rates all of the Big 4 banks hybrids as low risk except for the Commonwealth PCAPA which is rated at the lower end of medium risk (as it is perpetual).

Conclusions

While hybrids have share characteristics and attract a higher risk than term deposits and some other interest bearing securities, we continue to regard the Big 4 hybrids as low risk.

In the short term, we may see limited weakness in prices of hybrids before and immediately after Moody’s issue their revised methodology (late November). We continue our view that the Big 4 hybrids are a low risk means of achieving an attractive yield.