Given we’ve entered a new year, it’s usual that I’m asked for my view for the coming 12 months, and what investors should be considering with their fixed income investments.
Over the Christmas break, the biggest concern for investors was how the US would deal with the so-called ‘fiscal cliff’. While the Congress and the House of Representatives were able to find an agreement of sorts, it fell considerably short of what’s probably needed. The final outcome was a removal of the ‘Bush tax cuts’ for taxpayers earning more than $400,000, but left government spending largely untouched. In fact, a review of government spending was simply pushed back to a later deadline, however the impasse is unlikely to clear in the interim.
Other concerns
More importantly the concerns over the ‘fiscal cliff’ will be replaced by concerns over the US debt ceiling. In the US, Congress has to approve federal expenditure. Where tax receipts do not exceed expenditures (ie. a deficit budget), the Department of Treasury has to borrow to fill the gap. Under US law, the amount the treasury can borrow is limited by the debt ceiling, which can only be increased by the approval of the Congress.
In 2011, a crisis was created when the Congress refused to increase the debt ceiling as a ‘backdoor’ way for the Republican controlled Congress to stop, what they viewed, as excessive government spending. The impasse on the increase of the debt ceiling contributed to S&P downgrading the US credit rating from AAA for the first time in its history and the Dow Jones fell 5.6% in one day. Current projections have the US hitting the revised debt ceiling again in mid-February.
So how do I see this playing out?
Like the ‘fiscal cliff’, the issue will likely be avoided, but not resolved, however, in the interim, indecision, in-fighting and political posturing across the various levels of US legislature will see markets remain volatile, certainly in the first quarter, and likely the first half. With ongoing political paralysis, US companies will be unlikely to unleash their cashed up bank balances, which will be the true stimulus of economic growth and job creation in the US. Companies will remain cautious while this toxic political environment persists.
For me, the downside risks in this environment far exceed the upside risks. If the US is able to sort out its issues, then investors can take a more aggressive approach to risk. The opportunity cost of missing an upside pricing ‘pop’ are small, the downside risk if these issues drag on are more considerable.
So where to invest?
When there’s turmoil, safety should be an investor’s primary concern. For me, this means heading up the capital structure to the most secure structures – senior secured debt.
To cover short term turmoil, I’d look to secure infrastructure debt, which has a very low risk of capital depreciation. My preferred fixed rate infrastructure exposure currently is the Dampier-Bunbury Gas Pipeline issue, which matures in 2019 and offers investors a yield to maturity of 5.75%, a considerable up-kick from what’s available to investors from term deposits currently. This investment grade bond is ranked senior secured over the gas pipeline assets for what is a very basic business model. Gas from the fields around Dampier is fed through a pipeline to the customers in and around Perth. In the current environment, boring is good, and a gas pipeline is about as boring as it gets.
[1]The inflation genie
Beyond the first half of the year, the longer term risks to the economy will likely come from inflation. While currently inflation remains benign, continued stimulatory actions from the RBA (and reserve banks globally) may risk a breakout in the longer term.
The only true protection from inflation in the market are inflation linked bonds (ILBs), and sticking to my gas theme from above, currently there’s good value provided from the Envestra 2025 inflation linked bond, which is offering around 395bps above inflation. Given the RBA targets inflation of between 2% and 3%, a long term mid-point inflation assumption would see investors earning 6.45% from a senior secured investment grade bond. If inflation does breakout, the return for investors would be even higher.
Regardless, in my view ILBs should be a part of any investor’s self managed super portfolio for the capital protection they provide against the effects of inflation.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Also in the Switzer Super Report:
- Peter Switzer: Predictions for the US and Australia 2013 [2]
- James Dunn: How the listed infrastructure sector is faring [3]
- Ron Bewley: Consumer discretionary sector in focus [4]
- Paul Rickard: Question of the week – views on WAM and AUI [5]