Jan 12

The Kondratieff Wave and the Bond Market

Following commentary over the past three months on the Kondratieff cycle, the question has been raised as to how an investor can tell whether financial markets are in the upswing or downswing phase of a long wave.

During the upswing, private sector investment is strong and rising; share prices increase over time in real terms; and, reflecting buoyant economic activity, there is upward pressure on real interest rates.

By contrast, during the downswing, private sector investment is weak, equity indices are static or falling in real terms, and there is downward pressure on real interest rates.

It is relatively straightforward to identify whether financial markets are in a secular upswing or downswing by drawing time series charts of the annual average values of these three variables.

During an upswing, equities outperform bonds. This doesn’t mean that bear markets never occur in equity markets during an upswing – they can and do, but they will be relatively brief interludes in the upward march of equity prices. George Ross-Goobey, the pension fund manager of Imperial Tobacco, was therefore right to shift their funds out of bonds and into equities in the 1950s, during the early stages of the post-war upswing. He did so because dividend yields were higher than bond yields, and because he accurately foresaw that dividends would rise over time in line with the underlying growth of the British economy.

He was also right to shift out of equities back into government bonds (gilts) at the tail end of the post-war upswing. His obituary in the Telegraph in 1999 reported that, “By the end of the 1960s, Ross-Goobey perceived that the price of shares had risen perhaps too far with the emergence of the “reverse yield gap”, i.e. the yield on gilts was higher than that on shares, buying gilts heavily in 1974 when yields rose to over 15 per cent.”

This was at the beginning of a long wave downswing, and his timing was impeccable.

Though Ross-Goobey is long gone, the tactics he deployed through the long wave of his career remain valid today. The upswing of the Internet long wave broke on the international financial crisis of 2007-09 and we are now in a downswing. In such an economic environment, bonds represent a safer investment than equities and offer the prospect of superior returns over time. As noted in earlier comments, equity prices as measured by the FTSE 100 (and I suspect other international indices such as the Dow-Jones) have fallen significantly since the financial crisis, while bond prices have risen.

There is of course the risk that a distressed company could default on its bond payments, and the financial markets are pricing in this risk for the securities held in the Golden Guinea High Yield Portfolio. All 10 securities currently held in the portfolio are offering yields that indicate market participants believe they carry a significant default risk.

So too does the 11th security purchased this month, the senior bonds issued by International Personal Finance (IPF), currently quoted on ORB at less than 90 pence in the £.

IPF was spun out of the overseas loans arm of home credit company Provident Financial in 2007, since when it has pursued an active growth strategy particularly in eastern Europe and Russia. It operates through a network of 30,000 part-time agents, who advance loans to borrowers unable to access credit from the banks. This is reflected in high default rates, with IPF accepting that between 25% and 30% of the loans it advances will not be repaid, and the interest rates it charges reflect this risk. However, its business model is threatened by efforts by regulators, particularly in eastern Europe, to restrict high-cost credit. IPF announced in December 2015 that proposed legislation in Slovakia “will have a material adverse financial impact on its existing Slovak business”, following similar legislation in Poland.

These restrictions have led to a downgrading of IPF’s corporate debt. Equally, an earlier announcement accompanying the company’s third quarter results stated that “We expect to deliver continued strong growth in Mexico and through our digital businesses….Notwithstanding the challenges in growing the top line in our European home credit business, we are confident that the result for the year as a whole will be broadly in line with consensus,.”

This suggests that IPF’s operations are sufficiently diversified, both geographically and operationally, to ride out temporary turbulence in particular markets.

At current prices, IPF’s bonds offer a running yield of 7% and a yield to maturity in excess of 9.5%. If the High Yield Hypothesis (HYH) is valid, then financial markets tend to overreact to temporary bad news, driving security prices below their true value. The IPF bonds represent a test of this hypothesis.

Issuer: International Personal Finance Plc
EPIC: IPF1
Coupon: 6.125%
Maturity Date: May 8th 2020
Payment Dates: 6-monthly on May 8th and November 8th
Offer Price: 87.975
Running Yield (at Offer Price): 7.0%
Yield to maturity (at Offer Price): 9.6%
Nominal Amount: £1,000
Cost: £879.75 + £7.95 commission = £887.70

MJN
January 12th 2016

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