Taking Stock 14 February, 2019

Last week’s sharp decline in swap rates (benchmark interest rates) should not have investors reaching for the panic button, but it may soon be time to begin some gentle stretches of their preferred button-pressing limb.

The 1-year, 2-year and 5-year swap rates reached record lows towards the end of last week, which carries various implications for investors. These new interest rate lows may be a surprise, because most commentators believed the next move was upwards.

Firstly, investments priced with reference to this benchmark, such as the current Trustpower bond offer, will be set at a lower level than previously expected (although these bonds have a minimum rate of 3.95% for the first five years). Whether this is simply fortuitous timing, or a new normal, remains to be seen. We anticipate the latter.

Another example would be reset securities, such as Quayside Holdings (QHLHA) which resets its interest rate every 3 years. It is due to do so next year, using a rate of 1.7% plus the prevailing three-year swap rate. QHLHA currently pays an interest rate of 4.32%. If reset today, it would be closer to 3.5%. The risk has not changed, but the return has, impacted by the ongoing decline to interest rates.

The other key takeaway is that it reinforces our belief that general interest rates appear to be lacking a catalyst to head upwards. The opposite trend appears more likely: low interest rates that may be heading lower. This week already has seen ASB Bank reduce its term deposit rates, with the other banks expected to follow.

Investors who have adopted a ‘’long and liquid’’ approach over the past 5-10 years may currently own a fixed interest portfolio averaging a yield of, say, 5%. Those who own equities too would likely have done well, and be earning north of that figure.

As these old bonds mature, reinvestment into newer bonds, priced in today’s environment, will ultimately bring a lower return than investors have enjoyed.

If this were to occur, how would investors respond? How would investors change their behaviour if interest rates from term deposits and listed bonds were to drop even further?

Four logical options exist in my mind.

The most likely would be to increase risk. If investors begin seeing interest rates around 2-3% (gross) do they instead choose to take more risk? Investing in shares and Listed Property Trusts yielding closer to 5-7% gross becomes more compelling when the alternatives are bonds and term deposits yielding close to zero real return after tax and inflation.

One could argue that we are already beginning to see this, with share prices tracking upwards over the past week, coinciding with the slide in swap rates. Share price variations are rarely due to a single cause, but low interest rate environments are usually supportive to share prices, as we have witnessed in the US. If the expectation of falling interest rates was to eventuate, the early investors benefit the most.

A second option would be to adapt to the even-lower interest rate environment by further reining in spending. This may not be possible in many instances, where people’s expenditure is beyond their control (for example, on the ever-rising, inescapable rates bills and insurance costs). Trimming bone requires a much sharper knife than simply trimming fat.

The third option is to simply consume capital over time. While rarely the preferred option, spending your savings in a controlled manner makes more sense when interest rates are falling, as the alternatives may look less palatable. The rising popularity in Reverse Mortgage (Home Equity Release) schemes indicates that this option is becoming more acceptable to New Zealanders.

The last option is to increase your income. This option is an easier one for younger investors rather than retirees, who rely on political pressure to achieve such an outcome.

An illogical option would be to increase borrowings to invest in riskier assets, hoping that their returns exceed the cost of their debt.

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The Kapiti Coast District Council’s plan to do exactly that looks to have been (wisely) shelved for the time being.

The proposal, to borrow $20 million of low-cost debt to invest primarily in shares, appears to be overstepping the boundaries of their expertise, and exposing ratepayers to additional risk. Even choosing a fund manager to apply their expertise would be a risk that few councillors are equipped to handle.

Local Government have several benefits that may have led to the creation of this idea. Their ‘’revenue’’ (more specifically, council rates) is virtually guaranteed, and their investment horizon is practically infinite, allowing them to ignore the volatility of market cycles. However, when providing what would effectively be mandatory discretionary investment management services for their ratepayers, they appeared to have both eyes on the reward, and neither on the risk.

KCDC is one of New Zealand’s most indebted councils per capita, having borrowed heavily to fund infrastructural investment. Kapiti has seen growth in residential resource consents at a far higher rate than the national average, and is witnessing strong population growth following the eventual development of improved transport links to the capital (Transmission Gully in particular).

Readers of the Council’s long-term plan will be aware of an intention to lift rates by approximately 5% each year for the next three years. The median wage has not kept pace with this level for many years, nor the level of National Superannuation.

The proposal has attracted the attention of the Deputy Controller and Auditor-General, requesting further details around the financial and legal advice they intended to seek before furthering the proposal. The proposal was abandoned shortly after the Council heard from the Auditor General’s office.

While ratepayers should be encouraged by Council initiatives seeking to better control their finances, this idea was poorly conceived. Councils rarely have in-house capital markets expertise, and would be wiser to consider options other than sharemarket speculation to improve their financial management.

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Trustpower’s bond offer is open now, and anyone wishing to participate must confirm their interest by 5pm today. We request our allocation early tomorrow.

The offer is for a 10-year unsecured, unsubordinated (senior) bond, resetting its interest rate on the fifth year. The coupon (interest rate) will be determined on Friday, but will have a minimum of 3.95% for the first five years. Investors should anticipate a rate at this level, or very close to it.

The bonds will be listed on the NZDX, allowing investors to sell the bonds at any stage at the prevailing market rate, should the need arise.

Trustpower is a Tauranga-based listed company (stock code TPW) that is in the business of providing utility services across the country.

It is New Zealand’s fifth largest electricity generator and retailer. In both categories, Meridian, Genesis, Contact and Mercury (formerly known as Mighty River Power) are larger in market share.

Trustpower also offers telecommunications services. It is the fourth largest broadband supplier in New Zealand, behind Spark and Vodafone (together almost 70% of market share) and Vocus. About half of its customers use more than one product, which has been important to its success.

In 2013, Trustpower began a new strategy of offering ‘bundles’, where people receive discounts on their services by choosing to use Trustpower for electricity, gas and telecommunications. This has the benefit of reducing ‘churn’, as people are more reluctant to change electricity providers if it results in increases to their telecommunications bill. The strategy has been successful in increasing users of all three categories.

Investors wishing to participate in the bond offer, who have not indicated their interest already, should respond immediately.

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The Reserve Bank has kept the Official Cash Rate at 1.75%.

The full statement, made on Wednesday at 2pm (previously, these statements were made at 9am on a Thursday) indicated that the rate would likely stay on hold for the entirety of this year and next, implying the next move would occur in 2021 at the earliest. This was new information to investors.

Helpfully, the Reserve Bank clarified that ‘the direction of our next OCR move could be up or down’. The New Zealand dollar responded by climbing sharply, of course. Markets were obviously expecting a more dovish tone in the statement (that is, tending towards more stimulus by reducing rates).

The Reserve Bank has highlighted that a downturn in global growth, particularly among our trading partners, remains a risk. Oil price movements over the past two months are also likely to weigh down inflation.

The potential upside that it foretells is capacity pressures forcing up prices. This is particularly pronounced in the construction sector, where demand is (and has been for years now) exceeding supply. On an obvious local scale, there are problems in finding school teachers, train drivers, fruit pickers and retirement village nurses.

The Reserve Bank does not expect employment to increase, estimating that we are close to our ‘maximum sustainable level’. This will not be welcome news to some, and does suggest that many essential services will be understaffed as our population keeps growing.

Ultimately, the Reserve Bank judged that the current rate of monetary stimulus is appropriate for at least the next two years unless conditions change.

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Shareholders of Hallensteins Glassons (HLG) will be pleased following Wednesday’s trading update for the half year.

Its expectation is for sales to increase 3.1%, and profit after tax to increase 6% from the prior year.

The share price rose 6% on the back of the news. It reports its half-year results on 29 March.

Hallensteins has long maintained impressive dividend payments and like Briscoes, seems to be coping with the changing trends in retail.

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TRAVEL

Edward will be in Nelson on 19 February, in Napier on 25 February and in Auckland (Remuera) on 8 March.

David will be in Palmerston North and Whanganui on 18 February, Kerikeri on 4 March, and Lower Hutt on 20 March.

Chris will be in Auckland on February 25 (Albany) and 26 (Waipuna).

Kevin will be in Christchurch on Thursday 7 March.

Johnny Lee

Chris Lee & Partners Limited