The Weekly Update

Norway’s sovereign wealth fund (the largest in the world, at USD 850bn) announced earlier last week that it is looking to sue Volkswagen over the emissions scandal. According to the FT, as one of the largest VW shareholders, Norges Bank Investment Management is to seek compensation by joining one of the class-action suits being prepared in Germany, having suffered hundreds of millions worth of losses resulting from the scandal.

This did not stop VW from issuing into what has been a strong new issues market recently. Since the emission scandal broke out in September last year VW has put away around EUR 16.2bn to cover the costs. Volkswagen Finance (China) Co., Ltd. turned to the renminbi bond market to issue its first bond to Chinese investors; a 3.6% three-year deal totalling RMB 2bn (EUR 270m). Rated AA+ by China Chengxin Rating Company, the issue was 2.2 times oversubscribed. We have never held any VW credit within our portfolios mainly because we do not believe the bonds offer much value; the USD 2.4% issue maturing in 2020 for example has a risk-adjusted expected return and yield of only 4% (the yield element is 2.8%) and only 1.3 credit notches of protection, if we use the higher rating of A3 by Moody’s.

Another surprise deal was the fourth-largest bond offering in history, by Dell on Tuesday. With $85bn of reported orders, the total issue size was boosted from $16bn to $20bn and made up of 6 tranches. Rated Baa3 by Moody's, the only non-callable bond issued is the 3.48% maturing in 2019 which currently yields 3.12%. According to our proprietary Relative Value Model, the bond is currently trading at a “fair value” spread of ~200 bps over Treasuries with no credit notch uplift; this just goes to show just how desperate for yield some investors are.

We would rather hold Baa3 rated state-owned-and-run development bank, VEB 5.942% 2023 which has been one of the best performing bonds so far this year; having rallied almost 15 points off the January lows, to yield ~5.7%. The Baa3 bond remains attractive, offering a far superior risk-adjusted expected return and yield of 14.6% with 2.3 notches of credit cushion.

Away from the excitement of the new issue market, the FOMC minutes from April’s gathering released on Thursday erred on the hawkish side. Recent Fed rhetoric, where members have stated that anywhere between 2-3 rate hikes are possible this year, clearly indicate that the central bank is keeping the rate hike door wide open, allowing it the optionality to pull the trigger at any meeting. This news flow saw the dollar (DXY Index) rally a further 0.77% on the week, a move that, if continued, will put pressure on the indebted nations, as we have highlighted for the past couple of years. A weakening exchange rate is particularly damaging for indebted nations as it causes a rapid increase in net foreign liabilities as a % of GDP.

Back in February 2014 Stratton Street highlighted a list of countries likely to suffer a ‘dip’ in fortunes, these are countries where weak fundamentals have been ‘brushed’ aside or ignored, but are nonetheless vulnerable. Our view of ongoing deleveraging ‘paints’ a very negative view of countries with large net foreign liabilities, otherwise collectively known as "paintbrush". These “PAINTBRUSH” countries, in no particular order of level of concern, are Poland, Australia, Indonesia, New Zealand, Turkey, Brazil, Romania, Ukraine, South Africa and Hungary. As a guide, since February 2014 none of these countries’ currencies (spot rate) are showing a positive return against the US dollar: not surprisingly the Ukraine is the worst with the hryvnia down ~65% but even Indonesia, the best performer, is down 10%.

Perhaps Australia remains one of the more interesting cases as it is still rated AAA by all three major rating agencies. Australia, for NFA focused investors such as ourselves, with net foreign liabilities to GDP of -81.5% (Stratton Street’s estimates), remains a country to avoid.  It runs twin deficits and since 2009 Australia’s debt to GDP has risen faster than any of the other AAA sovereign credits. That said, gross government debt to GDP at 34.5% (Fitch) remains below the median for AAA at 42.8% and is one factor giving the ratings agencies comfort.

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