Back in 1958 animation wizards William Hanna and Joseph Barbera created a cartoon character called Yogi bear, famous for his statement: “… because I’m smarter than the average bear“. This year about at the same time summer turned into autumn, global bond markets have turned from bullish into bearish and it would be quite useful to know how to manage a bond portfolio in an environment like this. What would Yogi bear do if he was a bond investor? Find out in this article.
Germany avoided a technical recession by a hair’s breadth in 3rd quarter 2019 (this morning figures were +0.1% SA QoQ and +1.0% NSA YoY, versus gloomy expectations of -0.1% QoQ and 0.8% YoY), but still the growth numbers are really anemic and only the removal of Brexit impasse and US car tariffs could more significantly affect the output of the largest European economy.
Looking at the global political stage, S&P 500 has completely recovered from August tariff-induced dip and managed to reach new all-time high around 3.100 points. Global equity indices followed in a lockstep, EURUSD plunged while the notorious positive correlation between stock market indices and bond yields resurfaced in a broad bond sell off. The three yield curves (US, German and Italian) submitted below depict two important things to consider: first and most obvious thing is that long term yields moved north by about 30bps (depending upon the maturity of the paper); and second, parts of the yield curve that were inverted in mid-August (namely on US and German yield curves) are inverted no more. The front part of the curve is strongly affected by monetary policy decisions, meaning that short-term bonds are no longer pricing the prospects of cutting interest rates in order to spur economic growth. But more importantly, long-term yields moved up in the anticipation of stronger GDP growth and inflation ahead, which still need to materialise. All three yield curves are certain about one thing: markets are no longer afraid of a Bogeyman called global recession.
Could there be another leg to the bond sell off? On November 08th Messrs. Marko Kolanovic and Bram Kaplan from JP Morgan popped the question about whether rising bond yields could derail the great rotation from defensives/momentum into value/cyclicals. The rotation began in early September (JPM was calling it as early as July) and the first leg was limited to levered speculators’ short covering. You can easily see the rotation by comparing SVX Index (value stocks) to SGX Index (growth stocks) on Bloomberg by using HS function. Kolanovic & Kaplan point out that the second leg of this rotation would be unwound once the phase one deal is actually signed because by then the real money investors would jump in. This rotation would be consistent with rising bond yields, as JPM analysts point out that there might be significant groupthink and crowding out by CTAs in early and mid-summer; there’s a fair probability of this this groupthink being unwound, especially if the good economic data continue coming out.
It’s also worth mentioning that Goldman Sachs’ analysts (the most prominent among them being David J. Kostin) published “Flow of Funds Outlook 2020” in late October, stating that share buybacks will continue in 2020, although at a 2% slower pace compared to 2019. This year S&P 500 increased by +23.42% YTD in spite of share buybacks being close to 20% lower than in 2018 (net corporate purchases amounted to 598b USD in 2018, compared to expected values of 480b USD in 2019 and 470b USD in 2020). In the scenario of balanced economic growth (with trade risks dissipating), it’s quite likely that ETF inflows and household direct purchases would support equity prices next year.
So where does that leave us? Two large Wall Street financial institutions expect rising or steady equity prices in the near term and imply that environment would be supportive for rising yields. This means that the current bond selloff might have more room to run, especially if the JPM’s notion about crowded bond investing in the US is true. On the other hand, European pension funds have allocation limits, meaning that when bond prices, their percentage allocations of bonds relative to equities drop as well, leading them into bond buying to preserve the predefined ratios. Nevertheless, this effect might slow down the sell off, but it will probably not eliminate it altogether.
Speaking about Croatian EUR-denominated bonds, the chart submitted below demonstrate that since early September the Croatian curve gradually bear steepened. In our view, the change of the shape of the curve (i.e. more intense move on the longer part of the curve) was exacerbated by late profit taking on CROATI 1.125 06/19/2029, which is currently traded below 103.00. This would explain the belly on the second spot from the right on the black curve, and please note that the chart was composed using average prices (0.78% yield on CROATI 1.125 06/19/2029 implies a 103.17 price; market yield is close to 0.80%).
How do You hedge against this move if it becomes more severe into year end – or in other words, how do You invest smarter than the average bear? A typical hedge against bear steepening is moving on the front part of the curve, so it’s quite likely that Croatian investors might start selling the longer part and move into CROATI 3 03/11/2025, for instance. Buying put options on German Bunds appears to be too costly, especially after a rise in implied volatility following the recent move down in Bund prices. Croatian HRK bonds might be in trouble at this point in time: a typical investor with HRK-denominated balance sheet would be better off if he/she would be prepared to swap his local currency into euros for 6 or 8 months (and get at least 50 points in the forward leg, 0.14% annualized) and hence create a synthetic 2029 HRK exposure yielding 0.94% (0.80% from buying CROATI 1.125 06/19/2029 and additional 0.14% from FX hedging). The liquidity on the local bond market prevents selling local bonds in order to enter this trade on a larger scale, but still it will probably prevent investors from buying local 2029 paper at about 117.00 (0.56% YTM).
As NLB held a 9M 2019 pre-publication call, we are bringing you some key takes from it. Note that the company will publish their Q3 results on 29 November 2019.
Yesterday, NLB Group held a pre-publication call, in which the CEO and the CFO of the bank presented the Group’s operations in 9M 2019 and expectations for the following period. Blaž Brodnjak (CEO) touched upon the environment in which the Group operates and stated that they consider it a favourable one, which allows the growth of 2.5% to 3% YoY. In Serbia, the expected growth is even at 4% where NLB sees solid prospects for the bank as they have intensified cross-border lending. As a reminder, due to the EC commitments, NLB was not allowed to provide cross-border lending until the Slovenian State reduced their share in the company down to 25% + 1 share.
In the call, the management stated that NLB is in contact with ECB from whom they are waiting to allow them to embark again on leasing business. The Group already has factoring operations established in Slovenia and they are onboarding factoring platform in other countries. The management stated that the bank sees a strong demand for retail loans in Slovenia and regulator has reopened dialogue with them, so they hope that current terms under which consumer loans can be placed will be calibrated. The trend of regulators’ attempt to curb retail loans is evidenced throughout the region. NLB has a stance that restricting access to perfectly normal citizens credit is not healthy. In Serbia NLB was in a dialogue with the regulator and their voice was heard, so they do not expect measures to have an adverse impact on loan growth. In North Macedonia the action triggered by its central banks is still in its infancy so it remains to be seen how it will play out.
Financial results
When looking at financial results, which will be published on 29 November, the management has announced that in Q3 NLB has evidenced solid top-line growth while small tensions on interest income has been evidenced. The company is focused on a new set-up with transition of ownership in NLB Vita. Therefore, the bank is in the process of reviewing overall set-up in their distribution channel.
On the costs side, the bank expects to see a favourable development and on the level of the year, with costs expected to grow at very low single digits. In line with the company’s expectations, the head-count is decreasing as the bank is replacing some processes with digital responsibilities which they see as a positive trend that will continue in the next year. In Q3 NLB Group has evidenced NPL resolutions that will affect the results in a positive way. In the same period, the company has 2 large tickets that are release of provision on non-performing loans and are a results of regular healing activities. The bank still sits on book of 100% provisioned loans that amounts to EUR 900m gross so there is still potential for new releases in the future. The Group stated that they do not plan or predict this category as it is very volatile and with ageing these receivables mostly deteriorate.
On income tax the Group evidenced a bit of a reverse effect that what was seen in Q2 as they have adjusted their quarterly disclosure. On the level of the year the group expects 10-11% effective tax rate, the same as what was previously guided.
Target capital adequacy ratio remains unchanged as 16.25%. The Group has settled their financing requirements by closing bilaterally EUR 45m that will still not be evidenced by the end of Q3. Yesterday, NLB issued a note on a successful placement of EUR 120m Tier 2 subordinated notes. With this issuance, the Group has reached their full capacity with Tier 2 capital. It is also worth noting that NLB does not plan to issue additional Tier 1 capital at the time being. The bank currently holds annual ‘’Supervisory Review and Evaluation Process’’ dialogue with ECB and they hope that this current Pillar 2 guidance might come down for 25 to 50 pips.
In 9M 2019, sales increased by 25.9%, EBITDA increased by 95.6% and net income decreased by 1.8%.
Sphera Franchise Group published their Q3 2019 report. According to it, the company observed an increase in sales of 25.9% YoY, amounting to RON 694.3m. Such an increase could be attributed to the growth in the sales of USFN Romania (KFC restaurants) which increased by 17.1%, contributing 13.2 p.p. in the sales growth. Further, USFN Italy (KFC restaurants in Italy) observed an increase in sales of 222.4%, contributing 8.6 p.p. to the sales growth. Next, CFF (Taco Bell restaurants) sales grew 183.6%, contributing 2.7 p.p. to the sales growth. Also, (Pizza Hut restaurants) sales increased by 7.1%, contributing 1.2 p.p. to the sales growth.
Sales (9M 2019 vs 9M 2018) (RON m)
In 9M 2019, operating expenses amounted to RON 604.8m, representing an increase of 26.8%. The increase in operating expenses could be mainly attributed to the increase in the cost of labor and an increase in other operating expenses while being partly offset by a decrease in the cost of rent. Excluding the impact of IFRS 16, operating expenses amounted to RON 606.1m, representing an increase of 27.1% YoY.
As a result of the adoption of IFRS 16, rent expenses decreased by 4.9p.p. amounting to RON 16.1m, while depreciation expenses increased by 253.2%, amounting to RON 52.1m. General and administrative expenses amounted to RON 42.3m, representing an increase of 12.3%. Excluding the impact of IFRS 16 adoption, G&A expenses amounted to RON 42.6m representing an increase of 13.2%.
Going further down the P&L, EBITDA amounted to RON 102.5m, which represents an increase of 95.6%. If we were to exclude the impact of IFRS 16, EBITDA increased by 28.3%, to RON 67.2m.
When observing the company’s net financial result, Sphera recorded an increase in net financial loss from RON – 1.9m in 9M 2018 to RON -12.8m, in 9M 2019. The increase in loss could be attributed to the impact of IFRS 16 adoption (impact of RON 6.4m).
As a result of such change in net financial result, the company recorded a decrease in net income of 1.8%, amounting to RON 31.8m. Excluding the impact of IFRS 16, net income amounted to RON 38.2m, representing a decrease of 17.9%.