US Bonds are back and Challenger an intriguing play

Chief Investment Officer and founder of Aitken Investment Management
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Key points

  • US 10-year bond yields are not reflective of the US economy. They are more reflective of shockingly low long bond yields elsewhere, which make US yields attractive.
  • There is a high probability of many years of ultra-low cash rates, and a growing probability the RBA will have to drop the cash rate to 1.50%.
  • Challenger is a structural growth stock priced as a value stock.


If you told me at the beginning of 2014 that the Dow Jones Industrial Average would be 17,800 and the S&P500 2,070, yet US 10 year bond yields would be 2.23%, you would have won a lot of money off me. Below is an overlay of the S&P500 (in green) and US 10 year bond yield (in green) during 2014. There is no economic textbook that explains this. US economy and US corporate earnings accelerating, record highs for US equities, QE ended, bond yields fall from 3.00% to 2.23%. Go figure.

Bonds, James Bonds

All I can put this down to is US 10-year bond yields are not reflective of the US economy. They are reflective of an asset allocation to US dollar denominated assets and also reflective of shockingly low long bond yields in the rest of the developed world, which make US yields look relatively attractive.

No doubt I’d rather own a US long bond in US dollars over any other long bond in any other currency. Clearly, I’m not alone in thinking that and it’s been 100% the right positioning, as has being long US equities in US dollars.

Australian bond yields are falling for different reasons: our GDP growth outlook is being revised down, as our key commodity export prices plumb fresh lows. It makes fundamental sense that the spot prices we see in front of us today for iron ore, oil, coal and gold are leading to negative GDP revisions for Australia and a subsequent fall in short to medium term bond yields.

For the first time in nearly 18 months, Australian 3-year bond yields at 2.43% are below the RBA cash rate at 2.50%. The chart below confirms 3-year bond yields have been predictive of moves lower in the RBA cash rate, albeit by periods of three to six months. The question then becomes – is the RBA getting behind the curve?

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For the sake of the exercise, I have overlayed the AUD/USD cross rate to the chart above. This correlation reminds you that if the 3-year bond market is right in starting to price in lower cash rates in Australia next year then the Aussie/US dollar has another leg down to come.

Click here to view larger image

Great interest rate expectations

As you know I’ve been changing my positioning around Australian interest rate expectations for the last few weeks due to the speed and scale of the commodity price collapse. There is absolutely zero risk of domestic cash rate rises in the medium-term, a high probability of many years of ultra-low cash rates, and a growing probability the RBA has to drop the cash rate to 1.50% next year to offset fiscal austerity and our falling terms of trade.

The first element of this will be RBA’s officials changing their language to entertain the possibility of lower rates under certain macro conditions. This jawboning in itself may be enough to start taking further support away from the Aussie dollar.

Either way, with zero risk of domestic rate rises and medium-term risk of only stable or lower cash rates, what does this mean for domestic investors?

The play

Firstly, it means you need more US dollars and US dollar earnings streams. But I won’t play that broken record again.

Secondly, it means the price paid for relatively assured fully franked dividend growth will rise and that is why I have recently upgraded my Telstra price target and upgraded both ANZ and NAB to buy. I have also been pushing my top five “non-bank industrial yield” stocks (Telstra, IAG, AMP, Transurban, Wesfarmers) and interestingly yesterday as bond yields cracked, they all performed very nicely.

Outside of the search for yield in the equity market (and investment property market), it would be then pretty certain that our ageing population will go after the relative certainty of annuities.

Term deposit rates continue to fall and will fall further if cash rates are lowered in 2015. This is a problem for our ageing population, who are going to have to take some form of “risk” to generate the income streams they want to fund their retirement ambitions.

The ASX200 hasn’t delivered them capital gains this year and most are grossly under-exposed to offshore assets. Volatility has also increased this year, which is not a retiree’s friend.


Personally, I can see the drivers of structural growth in demand for annuities and the way to play that in Australia is Challenger (CGF).

CGF has been in my top five “trading buy” list since $6.60 but today I am going to upgrade it to a fundamental buy as I feel it is cheap and leveraged to a structural growth theme. I also think it’s a clear takeover target.

Australia’s ageing population is a huge structural theme that the equity market pays a big P/E premium for. From undertakers, through to private hospitals, pathology, nursing homes and even Medibank Private, the ageing population theme seems to attract a 20 times P/E multiple for assured medium-term growth.

However, when I look at Challenger, a clear demographic play on Australia’s ageing population, the forward P/E is half of the medical sector exposures to the same theme.

One of the reasons Challenger shares have underperformed since mid this year, is they raised fresh equity capital to accelerate growth. However, there’s a lag between the capital being deployed and earnings growth being seen. That sees EPS dilution in FY15 (-3% EPS growth), which is why the share price has stalled. Yet if you look at our forecasts below, that growth capital turns up as +15% EPS growth again in FY16 and the stock is cheap on all investment criteria. It even yields 5.00% fully franked on FY16, noting that 100% franking kicks in FY16. That is an important point.

There are many sceptics on CGF but most are conflicted, as they are a competitor in one way or another. It’s hardly like equity fund managers are going to cheer on the growth of annuities.

But this is a structural growth sector. It is currently being aided by cyclical factors such as ultra-low cash rates and increased volatility, but those cyclical factors won’t change anytime soon. In fact, they may well become more supportive of flow into annuity products.

The Challenger AGM passed without incident on October 28, in fact, it was quite upbeat with the Chairman confirming total assets grew by 13% to $50.7 billion in FY14.

To quote directly, “As you are aware, Challenger’s name is synonymous with guaranteed income investments and this year retirees invested $3.4 billion in our annuity products”.

This included a record $2.8 billion in retail annuities.”

Challenger is a structural growth stock priced as a value stock. This pullback in the share price, due to the perception of a growth less year, is a fundamental buying opportunity. As the market starts focusing on FY16 and the prospect of +15% EPS growth and a 5.00% fully franked dividend yield, Challenger will head to fresh record high share prices.

If you’re looking for non-bank industrial dividend growth, CGF is now one of my key fundamental ideas.

Go Australia, Charlie

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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