Why not all duration is created equal; and how best to gain a clearer view of Value?
August 27 2019
Not All Duration Is Created Equal
The bifurcation of the bond market continues apace. Figure 1 shows the price of two long-duration bonds – the Austrian government’s 100-year bond paying 2.1% and a perpetual bond issued by a major, well- capitalised European bank paying a 6.5% coupon.
What is striking is that the price increase for the Austrian bond is not being replicated for all assets of a similarly long duration. Whilst the bank bond is exposed to more credit risk than the sovereign issue, the difference in credit risk is not enough to explain the differing price action. Indeed, 5yr credit default swap pricing would suggest that the bank bond should have out-performed the sovereign (year-to-date, the former has tightened 49% vs 15% for the latter), indicating that creditworthiness cannot explain the relative move.
The two features, in our minds, that best explain this dislocation are that the sovereign has a dated maturity and is also highly rated (AA+), the bank bond is not. The buyer base for bonds in the former category is considerable larger, and indeed many such investors have liability driven mandates that make them forced buyers as swap curves tighten. This price momentum is then exploited and exaggerated by trend-following market participants. The demand technical for European bank capital seems less.
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As of 19 August 2019.
Our take-away from this observation is that if there is a bubble in duration, then it`s not for all long-dated streams of safe, predictable income. Bubble conditions seem most evident in instruments that tick the right boxes for a desperate buyer base who operate in an increasingly negative yield investment universe, competing with value agnostic central bank and momentum investors.
Towards a Clearer View of Value
Growth has consistently outperformed value over the last ten years, both in the US and in Europe.
A possible explanation for this value weakness may be the increase in the level of intangible assets (Figure 2). Under current accounting rules, most investments in intangibles assets are expensed rather than capitalised. This understates the earnings and assets of intangible- heavy firms.
The knock-on effect of this may be that value measures such as price-to-earnings (‘PE’) and price-to-book (‘PB’) ratios become less and less relevant. Figure 3 shows the reaction to meeting or beating consensus earnings by the level of intangible asset intensity. There is less abnormal price reaction to beating consensus for firms that have a high level of intangibles, while companies with fewer intangibles see better abnormal returns. In our view, this suggests that value may not be the issue. Instead, the issue might be that our definition of value needs to change.
Figure 2. Growing Investment in Intangible Assets
Source: Economists Carol Corrado, Charles Hulten, and Daniel Sichel (2009, p. 680) wrote: “What is surprising is that intangibles have been ignored for so long, and they continue to be ignored in financial accounting practice at the firm level.”
Figure 3. Decreasing Gains from Beating Consensus Earnings, 2011-2017
With contribution from Chris Huggins (Man GLG, Portfolio Manager), Rob Furdak (co-CIO, Man Numeric) and Yudi Lu (Associate Quantitative Researcher, Man Numeric).