In the gloom of the markets, I see a glimmer of hope

Like the coronavirus, markets can sometimes be “tricky”.  In fact, bond, real estate and share markets have been tricky if not downright rocky ever since the US’s Federal Reserve started raising interest rates last year to combat surprisingly resurgent inflation (note the Fed increased the fed Funds rate by another 25 basis points this week)  And the resulting consequences of these sharp interest rate rises are rather unpleasant everywhere we look: shares and bond portfolios have by and large lost money – asset class diversification didn’t work this time.  The costs of financing a car, mortgaging your house or even a small credit-card purchase have risen.  Three important regional US banks have failed and needed bailouts, causing further uncertainty regarding the stability of the US financial system while all of the above have spruced worries about a recession and the real-world consequences that entails.  But there is a glimmer of hope out there…

Share markets around the world tumbled in 2008 in the eye of the GFC.  The SP500 in the US fell a whopping 39% that year.  Our NZSX50 followed suit, starting the year at 4,041 and falling 33% to see the 2008 out at 2,715.  The NZSX50 took until the end of 2012 – that’s four long years – to recover the losses from 2008 and the bulk of those gains came from the 19% gain in 2009 and the 24% in 2012 as the intervening periods were somewhat flat.  That was a tough period for all involved in the markets at the time.  However, and while share markets were difficult to navigate (unless you could magically pick that bottom in 2008/9) there were some attractive investment opportunities elsewhere and in particularly the bond / interest rate market.  Uncertainty understandably pervaded the market environment at the time and in the wake of the GFC and many companies were rightly concerned about the outlook for their capital and cash flow and, more importantly, what the then future access to capital and liquidity might be.  These market characteristics and sentiment spurred a spate of capital raisings – both debt and equity securities – essentially as CFO’s and Treasurers raised money while they could, shoring up balance sheets, in case same were to become difficult in the future.  Prudent strategies indeed.  Fortunately (or unfortunately depending on one’s perspective) for the issuers of the debt securities , prevailing interest rates were high with investors finding the coupons on offer attractive.  I can recall buying some five year debt-type securities in both Kiwi Income Property Group (now Kiwi Income) and Fonterra with coupons in the 9-10% range while at the same time earning 8.83% from a term-deposit (three year I think) with ASB Bank.  And there were many, many more.  These yields were more than sufficient to attract the necessary investors and get the deals away, so the corporates were happy too.  And we investors certainly liked the rates on offer particularly over the next few years while share markets remained choppy in their recovery phase and, importantly, the yield curve dropped away with, something that subsequently became something of a household name:  Quantitative easing or QER…

So that period of economic and market uncertainty, high interest rates and a need for capital actually created some interesting / attractive opportunities for investors:  good quality debt securities or bonds at good yields.

And here’s the glimmer I mentioned earlier.  We are in a very similar set of circumstances at present which I think will provide some interesting opportunities.  The current set of circumstances characterised by uncertain economic outlook, choppy share markets etc have been added to by the quick, 500 basis point increase in our Official Cash Rate (OCR) to 5.25%.  This increase has caused the yield curve to shift up markedly across all terms.  This means that any debt securities coming to the market now or while these higher rates prevail will be issued at relatively higher coupons.  And therein lies the opportunity for investors:  the economic woes of the past couple of years and the spike in inflation have elevated the yield curve such that debt issuance now looks a whole lot more attractive to the investor.

Check out New Zealand’s five-year swap rate below: (source Refinitive)

Note the spike over the past few quarters.  There is another factor that makes the current circumstances even more attractive:  many economists and commentators are now calling the peak in the interest rate cycle  saying there will be at most one more 25 basis point increase in the OCR from here. Kiwibank economist Jarrod Kerr is even predicting OCR cuts from November 2023.  If this were to be the case – and I agree with Kerr– then by definition these high rates won’t last and the investment opportunity will no longer be there.  We have a window…

Certainly if we think about the levels of debt in the economy now, a sustained period of 5% plus cash rates seems very unlikely to last, and it’s probable that over a relatively short time we’ll drift back to a more neutral OCR rate of under 3%.  And in fact, this process could even unfold quite quickly, as the current RBNZ Governor has shown a willingness to make assertive moves in either direction when he feels conditions warrant it.

In summary, the current Investment environment feels to me a lot like the post-GFC period:  economic uncertainty / slowdown, market caution, suddenly high interest rates that won’t last and companies raising capital.  We saw Heartland Bank issue $100m of subordinated debt at 7.5% last week and Kiwibank is currently raising $200m at around 6.5%.   I’d expect more of these sorts of issues throughout this year with coupon rates of a similar range.  As we did in 2011 and 2012, in a few years from now we might look back to 2023 and dream of the bonds issued at such attractive rates “way” back in 2023.