Kreston market update week ending Friday 30th July 2010

Kreston ANZ

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Kreston Dormers

Kreston Dormers Financial Services Pty Ltd

This week's update is early due to the author's Friday commitments.

The ASX 200 had its 4th positive week in a row with Banks and Materials the standouts this week.

The appetite for risk has responded to good company results from the US and falling debt concerns in Europe. This news seems to have overcome pessimism for the moment over the slowing US economy and the longer term debt issues in Europe.

	Index	Change	%
All Ordinaries	4,542	77	1.7
S&P / ASX 200	4,531	84	1.9
Property Index	861	-4	-0.5
Utilities Index	4,171	-52	-1.2
Financials Index	4,441	110	2.5
Materials Index	12,091	198	1.7
Energy Index	14,752	75	0.5

Bank Term Deposit rates were little moved this week.

Term	Rate %	Change in rate
3 months	5.60	-0.05
6 months	6.00	0.00
12 months	6.11	0.00
3 Years	6.80	0.00
5 years	6.95	0.00

Overseas markets were positive. The US S&P 500 rose +1.2% as positive company news and housing market data increased optimism that the economic slowdown would be less pronounced. The UK FTSE was 0.1% stronger. It has risen for the past 4 weeks in a row and is up by over 10% in that period. In Asia, Hong Kong's Hang Seng rose 2.3% and Japan's Nikkei was 3.2% stronger.

In Australia, QBE downgraded forecast profits while Wesfarmers surprised on the upside.

In this week's Feature Section we discuss credit markets and interest bearing securities.

Australian News

Wesfarmers (WES) released their fourth quarter sales for their Coles business. Total sales were up a higher than expected 4.5% and the important Food and Liquor sales grew 4.2%. The results were in contrast to recent Woolworths sales which showed more subdued growth. There is probably a 'natural' market share of Coles which it is claiming back after its lack of success under previous management.

Insurance company QBE released a first half 2010 forecast with Net Profit After Tax down approximately 40% from the first half of 2009. The fall was attributed to lower returns on equities and also lower interest rates. Insurance companies invest insurance premiums to cover future claims from policy holders. QBE is more conservative than most other insurance companies as it predominantly invests in bonds and other interest bearing securities. US official interest rates are near 0% at present which has been hurting QBE.

The 'good' news was that QBE expect their margins to meet previous expectations. Operationally the company is delivering. 'More normal' credit markets would assist QBE.

Rio Tinto signed a $US4 billion program with Chinese company Chinalco to develop iron ore deposits in Guinea, West Africa. A Chinalco offer for a major stake in Rio Tinto was rejected last year and was a key factor in rising tension between Chinese steel producers and Australian iron ore producers, Rio and BHP. The deal has raised concerns over increased control China may have over iron ore production/prices in the future.

The Consumer Price Index (CPI) gave us the standout good news this week with underlying inflation sliding to 2.7% in the twelve months to June. The RBA has a mandate to keep inflation within a 2% to 3% range and the reading should mean the RBA holds rates at 4.5% in their meeting next week.

Overseas News

Overseas share markets have risen over the past couple of weeks on the back of solid results from US companies in the current reporting season and no surprises in the European bank stress testing that was tabled at the end of last week. Also Credit Default Swaps (CDS), which measure the cost of insuring against a default, have been falling for European countries although are still at elevated levels.

Once the US reporting season completes we expect attention to focus on economic growth numbers.

It is clear that the US is slowing but the extent of the fall will be the test. Most analysts expect the US to stay out of a double dip recession although some are now calling for an additional stimulus to the US economy. The US Federal Reserve in their June Beige Book report stated that while economic conditions continued to improve in most of the US, the rises were modest. Retail sales posted only small gains, housing remained weak and bank lending was still tight. Consumer confidence numbers this week supported this slowing trend although these numbers tend to be impacted by how the share market is travelling (i.e. it fell in June).

In Europe, the message is much the same as there has been heavy government spending cuts which will start to impact growth. The question will be how much private sector activity can offset the declines due to the government spending cuts. As a positive, the UK this week reported GDP growth of 1.1% for the June quarter.

The results of stress tests of 91 European were released last Friday night. There was considerable comment that the scenarios tested were not stressful enough. For example, there was no test against say Greece defaulting. That would be too politically sensitive. Instead the banks tested a scenario where Greek government bonds declined 23% which is significant but not a default.

The positive was that the tests did not reveal any major unknown weaknesses. The seven banks required to raise more capital were the expected culprits.

Feature Article

We have been fielding a lot of questions of late on Interest Bearing Investments which form a significant part of portfolios. We touched on the subject when we reviewed how we assess hybrids in our Update of 27th November 2009. This Update will be less specific as it discusses concepts and assessment relating to Interest Bearing Security more generally.

Credit, Bond, Debt markets

The market for these types of investments is often called the 'credit, bond or debt markets'. Definitions vary and terms are used interchangeably at times but the markets include:

  • Corporate (companies borrowing via bonds)
  • Government (sovereign and state debt)
  • Municipal (in Australia - councils)
  • Mortgage Backed Securities, Asset Backed Securities and Collateralised Debt Obligations (CDO's) (basically the company's borrowing is backed by some form of security such as a sub-prime house, commercial property or guarantee from a third party such as a bank).
  • Funding (lending or funding to companies)

The size of the Bond Markets

The size of the credit market is very difficult to assess and estimates vary widely. Merrill Lynch estimated the size of the bond market to be $US67 trillion in September 2007. Credit markets are much larger than share markets (estimate at around $US37 trillion).

You will note that the above definition does not include derivatives such as credit default swaps (insuring against a bond defaulting) or interest rate swaps (switching between variable and fixed interest between two parties).

As credit derivatives have no central recording mechanism (that is something US regulators are addressing), it is difficult to assess what the exposure might be. One estimate is that the exposure is around $US1,000 trillion. I am not sure how this is arrived at given the difficulty in determining who owes who and how much. Suffice to say that whatever the number, it is huge.

This lack of transparency is a story in itself and in fact is behind two of the most recent credit crises i.e. Long Term Capital Management in the late 90's and the recent sub-prime meltdown.

Assessing an interest bearing investment

There are a myriad of variations to interest bearing investment so the terms below are some of the key factors we use to assess an investment.

  • The strength or credit worthiness of the issuer. This is the ability of the company to repay debts when they become due. Government bonds are typically a 'safer' investment but suffer from low returns. Company bonds are less available to retail investors and those that are available had not met our credit strength tests at the time. At present we are only recommending hybrids and term deposits issued by Australian banks.

Creditworthiness is the most important factor when assessing a potential investment.

  • Ranking of investors should the company be wound up, or 'Who gets their money first?' The following chart shows the ranking of different types of company capital:

Senior Secured Debt	Debt secured by say a debenture over the company or receivables. In a wind up the proceeds of sale of the secured assets are used go to repay the debt
Senior Debt	Debt without security. Debt is repaid from sale of assets but not those that have been used as security for other debt (unless there is a surplus after selling the asset).
Subordinated Debt	Repaid after the senior debt
Hybrids	Repaid after senior and subordinated debt.
Equity	The shareholders get what is left.

  • Yield. This is the return on the investment. However it is not that simple as some securities are issued at a discount and interest rates can be variable. Yield can be described in a number of ways:

    + Nominal Yield % = (annual $ interest paid/face value) x 100. Payments are made during the course of investment. Interest paid may be fixed or variable and the face value (the principal amount to be repaid) is the amount invested and will be repaid on maturity.
    + Running yield % = (annual interest paid/market price) x 100. The difference to the nominal yield is that market price is used instead of face value. The market price of a bond or hybrid may vary from day to day. For example, the face value of the CBAPB hybrid is $200 whereas the market price of the security is currently $193.25.
    + Yield to Maturity. 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. It is the most useful when comparing between securities. For example, the Commonwealth Bank CBAPB can be purchased for $193.25 and at maturity in 2 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 ($6.75) is added to the current gross interest (5.56%) the Yield to Maturity becomes 7.62% 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 securities with a Mandatory Maturity Date. As a general rule the shorter the term to maturity the less the risk.

  • Fixed or Variable Interest Rates? It is expected that interest rates are likely to rise over the next year or so in Australia although this is dependent on the global economy continuing to expand. We prefer to keep fixed rate investments terms (e.g. term deposits) to no longer than 12 months at the current time due to the expectation of rising rates.

  • Government Guarantees on Deposits. The government guarantee on Term Deposits will be in place for retail investors for amounts up to $1 million until October 2011 at which time it will be reviewed. This does reduce the risk of an investment as you are in effect lending to the government rather than the bank. However the government has never stated how quickly it would repay depositors if there was a call on a guarantee. The value of a deposit could erode quite quickly in times of high inflation. Consequently, my view is not to rely too heavily on the guarantee when assessing the attractiveness of a security.

Conclusion

Interest Bearing investment are the defensive part of a portfolio and consequently we look for security first and then expected return when assessing an investment.

At the present time, Australian retail investors are not well served for government bonds nor for that matter company bonds of what we consider of a high quality at a reasonable return. The securities we are prepared to recommend as they pass our risk analysis are reasonably limited in number. Nevertheless we are constantly looking at opportunities to broaden the number of recommended securities.