At the very start of Unlisted Gems, we mentioned that interest rates would be on the increase, sooner or later. Well, just a few months on, both the sooner and the later have been dropped and interest rates are rising. At the very beginning we set the project out not as a list of items to invest in, but a diverse array of what’s possible in each asset class so you could begin your own research and be aware of the multitude of unlisted and alternative options that are available in Australia. What we’ve got is a diverse array of investments that will respond to changing economic conditions in different ways.
Interest rates are now officially on the move: the impact on the Unlisted Gems (and indeed on everyone) depends on three factors: how fast, how high and why are they rising? After a number of years of slow growth and low inflation, the expectation of a rapid and substantial increase is still low. The consequences of a rise generally are discussed here ($).
When considering investment implications, investors need to consider a number of issues around rising interest rates:
- What are the implications for returns? What are the implications for capital gains? These are two different, but related issues.
- What will happen to the level of risk you’re exposed to?
- What time horizon are we considering? By and large, most of the Unlisted Gems are a long term proposition.
- What is your investment objective? Is this investment an overall return booster (with higher risk attached)? Is the investment intended to be low-correlated with the rest of your portfolio? Is the investment chosen for income, for growth or both?
An implication of many economic opinions is that rates are rising because economic growth is also rising (or expected to rise). Secular stagnation is over and there will be a new ascendancy of fiscal stimulus over monetary stimulus, which has no shots left in the barrel ($). On the other hand the “black swan index” is high ($) and there’s a lot of volatility about indicating high levels of uncertainty ($).
A lot of the opinion surrounding future growth is predicated on the assumption of fiscal stimulus in the US and that assumption has me concerned. The Republicans consistently moved against expansionary stimulus during Obama’s term in office. Hanging any analysis of the economy on what Trump has said he will do is one thing, but an ascendant Republican party in control of house, senate and executive government could reduce spending in other areas at the same time as rolling out a stimulus, which may reduce its effect substantially. The Economic Policy Institute published some scenarios and possible impacts for longer-term infrastructure spending in the US back in 2014 and they had a pretty interesting take on how much stimulus like that could impact the economy.
Another issue that hasn’t been well-covered in my view is timing. Trump takes office in January 20: how long until a stimulus bill is designed, approved, makes it through the machinery of government is enacted and then starts building walls, bridges, roads or whatever it is they decide to do?
In the global financial crisis, the Australian school halls and pink batts stimulus were chosen specifically to impact the economy as quickly as possible. Large scale infrastructure takes much longer to develop and longer still to impact the economy. The US economy is going to be living in hope of that happening for some time yet. And hope is really just another word for uncertainty. It may well happen: but not immediately.
US economic growth is one thing, but what about Australia? As a small, open economy we are impacted not just by the US, but by China (economic challenges ($)), Japan (ditto but different ones) and our other trading partners. Our GDP retracted in the last quarter, it didn’t grow (though I think there is some encouragement in the recent productivity statistics).
So the upshot here is that I don’t think we are going to see a precipitous rise in interest rates yet. The Fed believes there could be as many as three rises next year, but the Fed had a very similar position this time last year and only made one interest rate increase. Economic growth is not nearly as assured as we’d like it to be. Not everyone agrees with me there, some people think inflation is on the move (and it is in certain sectors), that growth will be strong, the stimulus will go through and rates will go much higher. In my first Unlisted Gems piece, I mentioned if you put two economists in a room, you get 3.7 opinions and an argument about whether opinions can be considered in decimals – case in point.
So where does this leave our Unlisted Gems? They’re a diverse bunch, so let’s break them down into groups:
The Bonds and the Bond Funds.
It’s important to distinguish between the types of risk you’re exposed to when considering these products. There’s the risk of reducing income streams and the risk of capital loss. There’s also the difference between partial capital loss (the investment I made yesterday is worth X% less today) and a total capital loss (100% loss).
In the case of fixed rate bonds, the rising interest rate makes them less attractive and reduces their value to buyers, but the income they pay is nominally constant (it does get degraded by inflation): so there is a consistent income stream, but at the moment there is also partial capital loss. A total capital loss isn’t on the cards, however: a government bond from the US or Australia itself is a safe bet. However, as Steven Koukoulas pointed out, being a government bond is no guarantee on its own.
Fixed interest bond funds like Henderson or Pimco that have a large holding of government bonds with rising yields (falling prices) are likely to experience substantially reduced returns as those capital losses occur. Those bonds are worth less now than they were a few months ago. In fact, PIMCO is now reporting a negative return on its financial year to date. Henderson, with a more mixed portfolio is also reporting negative returns for the last six months ending November (albeit these negative returns are pretty close to zero).
Does this mean it’s time to get out of either fund? I don’t agree that bonds are no longer safe havens ($) I think we are in a period of readjustment and that any fund with a heavy allocation to government bonds is going to suffer while that plays out. This may create buying opportunities as we go on, but as always: eyes wide open. The six-month rate of return isn’t a good indicator of long term outcomes, either, so bear that in mind.
Not everyone is entirely gloomy on the fixed interest group of investments, however. Realistically though, at least for the next while, we can expect to see substantially reduced returns as the adjustment goes on: one commentator summed it up pretty accurately with the word “bumpy”.
The Supervised Investments fund is in a different category as it’s focussed on floating rate securities, by contrast they are reporting a 4.18% return over the last six months to 30 November. As interest rates are increasing and bond yields rising, floating note securities are increasing the income they pay their holders and are not as exposed to the bond market downturn as fixed rate government bonds (on the flip side, when interest rates are falling, their return is reduced).
FIIG makes a good point about nuances in the bond market that’s worth underlining: corporate bonds and government bonds are different and are behaving differently. So Adani Abbott Point (new FIIG update here and coverage here) and the others we profiled aren’t necessarily in the same basket as government bonds.
It’s also worth making a note about the objective of these bonds in a portfolio: we have never made the case that at the end of a thirty-year bull market they were a good capital-gain choice. Rather as an income generator they are an option (albeit one with a higher risk and yield than some others you might choose). The income generating aspect of those corporate bonds hasn’t changed. What about capital risk? FIIG has a good analysis there too.
Peer-to-peer lenders generally.
We will probably see rising interest rates across the peer-to-peer offerings as companies move in line with the banks, either directly by setting those rates or driven by their internal markets (like RateSetter). The biggest concern here is the possibility of an economic downturn affecting (in particular) personal lending. The La Trobe offering, especially the high yield offering on second-charge mortgages could also be exposed in this context. However, as we said earlier, being aware of the risks and your appetite for them is critical. Mortage arrears are on the rise which is a concern for a product like La Trobe. Those arrears could be correlated with arrears in personal lending, such as those at Investors Central and RateSetter.
Most peer-to-peer offerings are fixed rate for the term of investment, so the income aspect is locked in. I spoke to Ben Milsom at RateSetter, about what changes we might expect to see in a changing macroeconomic environment in marketplace lending and Ben made the case that the efficiencies the platform generates still exist in a broader macro environment. In the case of RateSetter, the business won’t be increasing its rates directly: that will be up to the supply and demand of their internal lending market.
Investors Central is different to the other peer-to-peer lenders we profiled as it acts as a type of unrated corporate bond. The fundamental business model is marketplace lending, but the way it’s structured means the product is a debt instrument for all intents and purposes. It’s worth remembering with this one, although it’s a fixed rate product (like the other peer-to-peer offerings): a preference share’s status in the capital hierarchy changes as the instrument matures. Investors Central a very highly geared company with a gearing ratio of 85% in the latest prospectus – this is because its core business is borrowing money to lend out. The company has no secured or unsecured finance creditors ranking in priority to the preference shareholders.
So if you’re considering this one, bear in mind (as we said at the time), it’s got some substantial risk and make your plans accordingly with regard to term and the amount you invest. The critical point with this product is that highest yield does not make the product necessarily right for you: understand the risks and the possible outcomes in their whole context. As I said in our profile, an economic downturn is one that could impact Investors Central (or any marketplace lender) negatively.
One thing I do want to underline is that these peer-to-peer products shouldn’t be considered an alternative to investment-grade, high-rated bonds, term deposits or savings. As we said from the outset, there’s a substantial suite of risks and business models are still being tested. These products aren’t in for the same kind of bumpy ride as the fixed income bond funds in the immediate future, but they don’t have the same level of long term capital security. It doesn’t make them necessarily better or worse: it makes them different.
Just like the bonds and bond funds, we had a wide array of options here. Some were highly specific like the Blue Sky Water Fund. While they’re not having the greatest few months, that’s got very little to do with interest rates in my opinion and a lot to do with all the water that’s been falling on the ground. I suspect this fund will just continue to get on with things without too much regard to interest rates.
I think the bigger concern for this fund is international trade: a lot of the high value growers who are prepared to pay a premium for water are growing for an export market. Their continued access to that export market will help drive water prices. So far, there is no expectation of trade being rolled back with key Asian markets, but the anti-trade sentiment in some parts of the world and government intervention in the water market is my biggest macroeconomic concern for the Blue Sky Water Fund going into the long term.
Funds that focus on unlisted infrastructure like the Infrastructure Partners Investment Fund may experience some adjustment as valuations take into account the rising interest rates and capital moves to other cyclical investments. However, fundamentally, these are still the same businesses providing essential and monopolistic services. I spoke to Nicole Connolly from the Infrastructure Partners Investment Fund about what kind of effects there could be. She believes the risk-free rate impacts unlisted infrastructure in two ways:
- The discount rate used for valuation: as interest rates increase, the discount rate increases too. However, valuers tend to take a long-term view on this point.
- Operating cash flows: debt costs increase, but interest rates also influence revenues. In regulated businesses, allowed returns are likely to increase, while GDP assets tend to increase with inflation and economic growth. Increasing interest rates are usually a response to that.
Core infrastructure, in Nicole’s opinion, is likely to be relatively insulated to changes in the interest rate. Nicole described to me an analysis by the Hastings Trust that suggests a rise in the Australian risk free rate of 1% over a 12 month period had around a 0.5% negative impact on returns over the long run. That’s a pretty robust outcome.
The unlisted funds that invest in listed infrastructure may also experience a period of revaluation, especially as money that moved into infrastructure because of its bond-like characteristics may begin to move elsewhere. We canvassed this possibility in our introduction to infrastructure. This group includes Magellan, Rare and 4D infrastructure fund. That may impact yields, so that is something to be aware of.
One thing to note, especially with this group: if you want to invest in these products (or indeed any at all) because they may have a low correlation with the ASX, query that with the company prior to making a decision. Ask them how low that correlation is, over what period of time. Does it include periods with downturns?
Again, we had a diversity of options covered here. Single-building investments like the Blue Sky Student Accommodation fund will find that gearing will become more expensive as interest rates increase, but since a precipitous rise isn’t on the cards at this point (in my opinion), that doesn’t augur a crisis in my view. What will be interesting is the fund’s key customers: international students. With a rising US dollar (directly impacted by rising interest rates), we may see more students from the US and more from Asia, as Australia becomes a cheaper destination to study in comparison to the US. This will increase demand for the product, which I think will be a net positive.
Commercial-focussed REITs should do OK ($), but like infrastructure funding expenses will increase and there will probably be a rebalancing as money flowing out of bond-like instruments readjusts valuations. Like infrastructure, if the quality of the product is there and the economic conditions remain reasonable, then the income aspect of the investment should continue. Capital valuations inflated by the conditions in other parts of the cycle may change and that will likely reduce overall yield, at least for a while. Again, this was a possibility we canvassed early on. In REITs with long weighted average lease expiries, I think the biggest issue is going to be increased funding of gearing costs: however gearing levels in REITs have dropped a lot in the last few years ($) and that’s good news. So far this sector is doing well, but realistically, we should expect to see a dampening of expectations of yield at least in the short term.
And Venture Capital?
Well, this one’s a tough one, because it’s very specific to the investment itself. Most of the companies invested in by Venture Capital that we’ve looked at don’t have debt: so interest rates aren’t a huge issue for them individually. However, the economic growth of the economies they’re working in is going to be a factor in their success and ability to grow.
The outcomes for the Unlisted Gems are as diverse as the Gems themselves. Some are in for a bumpy ride: bond funds invested substantially in fixed government bonds especially. Others are exposed to increased risk if there is an economic downturn like the peer-to-peer options. Any of the Gems whose fundamental assets can be traded on a secondary market of some kind may experience revaluations as capital moves out of infrastructure, REITs and bonds and into other options more attractive in a rising interest rate environment. However, as we’ve always said these are long term investments in general and the fundamental business matters the most.
It’s important to remember that unlisted or alternative investments form just one part of a diverse portfolio. They’re there to pick up the slack when the equities market, property or your other investments are lagging. Those roles get reversed from time to time and we’ll see some of that now. To finish, Morningstar had some advice recently on how not to kick an investment own-goal: top of the list was don’t make hasty sell decisions based on macroeconomic news. That’s good advice for all investing, unlisted or otherwise.