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Dancing with the devil

  • We continue to experience a remarkably stable loan book performance when considered in the context of the first Australian economic recession in 30yrs.
  • In fact, the price at which various asset classes are trading suggests the monetary stimulus provided by the Reserve Bank and its global peers are driving near record risk seeking by some financial institutions and fund managers who must deploy their investment mandates. This more than supports the values underpinning our lowly geared loans.
  • In discussions with the world’s largest prime brokers over the last week they are reporting credit funds and hedge funds are holding the highest gross leverage positions they have seen in the last decade. A clear sign of solid risk taking by professional investors.
  • One example of intended central bank intervention which is driving record risk taking is the recent announcement by the RBA to extend the Term Funding Facility to Australian Banks. This program enables banks to borrow another $100bn at 0.1% for 3yrs, which in our opinion is unquestionably below the price they would otherwise need to pay for capital to justify the risk.
  • The banks can now secure much of their own funding without having to go back to the bond market for the expected or usual quantum. Less issuance of bonds results in more competition from buyers who need to deploy cash to this low risk asset class. As a result, credit spreads are the tightest we have seen since founding Merricks Capital 13 years ago.
  • It does feel that some participants in property, infrastructure, equity and credit markets are “dancing with the devil” by assuming the current money supply chain that is fuelling asset prices is a fair reflection of risk vs return.
  • The micro shock in the bond market on Monday which saw a dramatic sell off in bonds and one of the worst days in long short equity hedge fund performance history suggests there are some warning signs in the microstructure of markets. Most of the world was oblivious to these shocks as stock markets surged but we are seeing some reason to be vigilant as it was this type of gyrations during 2007 and 2008 that proved to be the canary in the coal mine.
  • Within our own portfolio the underlying loans are performing generating 0.7-0.9% per month, however the insurance portfolio we own continues to detract more than we would have expected. The chart below disaggregates the Partners Fund performance with and without the insurance.
  • Chart 2 & 3 highlight the ever-tightening credit spreads of both senior and subordinated debt for the four major Australian Banks. The near record low spreads make sense in the context of the central bank liquidity discussed above, however they make no sense in the context of market participants willingness to hold bank credit for close to zero return in a recessionary environment.
  • For investors in the Partners Fund it has meant a little more upfront cost than expected due to the mark-to-market of carrying insurance, but much lower than expected premiums now to be amortised in future months.
  • In our opinion it makes sense to keep buying this insurance as the world has never been so uncertain relative to market prices that suggest there is nothing but smooth sailing ahead. To be clear this is not stating that we believe there is an imminent crisis but rather the price at which many assets are trading just does not account for any potential risk.