Etikett: CDS

Vad är en Swap för något?

Vad är en Swap för något?

En swap är ett derivatkontrakt genom vilket två parter byter kassaflöden eller skulder från två olika finansiella instrument. De flesta swappar involverar kassaflöden baserat på ett nominellt huvudbelopp, såsom ett lån eller obligationer, även om instrumentet kan vara nästan vad som helst. Vanligtvis byter räntan ”ägare”. Varje kassaflöde består av ett ben i swappen. Ett kassaflöde är i allmänhet fast, medan det andra är variabelt och baserat på en referensränta, flytande valutakurs eller indexpris. Vad är en swap?

Den vanligaste typen av byte är en ränteswap. Swappar handlar inte på börser och privatpersoner investerar inte i allmänhet i swappar. Swapar är over-the-counter kontrakt främst mellan företag eller finansinstitut som anpassas till båda parternas behov.

Ränteswaps

I en ränteswapp utbyter parterna kassaflöden utifrån ett nominellt huvudbelopp (detta belopp utväxlas faktiskt inte) för att säkra mot ränterisk eller spekulera. Tänk dig att ABC Co. just har utfärdat 1 miljon dollar i femåriga obligationer med en rörlig årlig räntesats som definieras som London Interbank Offered Rate (LIBOR) plus 1,3% (eller 130 punkter). Antag också att LIBOR är 2,5% och ABC-ledningen är oroliga om en räntehöjning.

Ledningsgruppen finner ett annat företag, XYZ Inc., som är villigt att betala ABC en årlig andel av LIBOR plus 1,3% på en nominell huvudstol på 1 miljon dollar i fem år. XYZ kommer med andra ord att finansiera ABC: s räntebetalningar på sin senaste obligationsemission. I utbyte betalar ABC XYZ en fast årlig ränta på 5% på ett teoretiskt värde om 1 miljon dollar i fem år. ABC drar nytta av swappen om räntorna stiger avsevärt de närmaste fem åren. XYZ gynnar om priserna faller, håller sig platt eller stiger bara gradvis.

Nedan finns två scenarier för denna ränteswap: 1) LIBOR stiger 0,75% per år; och 2) LIBOR stiger 0,25% per år.

Scenario 1

Om LIBOR stiger med 0,75% per år uppgår bolagets totala räntebetalningar till sina obligationsinnehavare under femårsperioden till 225 000 USD. Låt oss bryta ner beräkningen:

I det här scenariot gjorde ABC rätt för att räntesatsen fastställdes till 5% genom swappen. ABC betalade 15 000 dollar mindre än det skulle ha med den rörliga räntan. XYZs prognos var felaktig och företaget förlorade 15 000 dollar genom swapen eftersom räntorna steg snabbare än vad de hade förväntat sig.

Scenario 2

I det andra scenariot stiger LIBOR med 0,25% per år:

I det här fallet skulle ABC ha klarat sig bättre genom att inte delta i swapen eftersom räntorna steg långsamt. XYZ tjänade $ 35,000 genom att delta i swapen eftersom dess prognos var korrekt.

I det här exemplet redovisas inte de övriga förmåner som ABC kan ha fått genom att delta i bytet. Till exempel kanske företaget behöver ett annat lån, men långivare var ovilliga att göra det om inte ränteförpliktelserna på sina andra obligationer fixaderades.

I de flesta fall skulle de två parterna agera genom en bank eller annan förmedlare, vilket skulle ta en del swapen. Huruvida det är fördelaktigt för två enheter att ingå en ränteswapp beror på deras komparativa fördel i fasta eller flytande lånemarknader.

Övriga swaps

Instrumenten som byts ut i en swap behöver inte vara räntebetalningar. Det finns otaliga sorter av exotiska swapavtal, men relativt vanliga arrangemang inkluderar råvaruswappar, valutaswappar, skuldswappar och totalavkastningsswappar.

Råvaruhandeln

Råvaruswappar innebär utbyte av ett flytande råvarupris, till exempel Brent råoljeprispris, till ett fast pris över en överenskommen period. Som det här exemplet antyder handlar Råvaruswappar oftast om råolja.

Valutaswappar

I en valutaswap byter parterna ränta och huvudbetalningar på skulder i olika valutor. Till skillnad från en ränteswap är räntan inte ett teoretiskt belopp, men det utbyts tillsammans med ränteförpliktelser. Valutaswappar kan ske mellan länder. Kina har till exempel använt swappar med Argentina, vilket hjälper de senare att stabilisera sina utländska reserver. Amerikanska centralbanken genomförde en aggressiv bytesstrategi med europeiska centralbanker under den finansiella krisen 2010 för att stabilisera euron, vilket sjönk i värde på grund av den grekiska skuldkrisen.

Skuldsättningsswappar

En skuldsättningsswappar innebär utbyte av skulder mot eget kapital – i fråga om ett börshandlade bolag skulle detta innebära obligationer för aktier. Det är ett sätt för företagen att refinansiera sin skuld eller omfördela sin kapitalstruktur.

Avkastningsswapar

I en Avkastningsswap byts den totala avkastningen från en tillgång till en fast ränta. Detta ger parten som betalar den fasta räntexponeringen för den underliggande tillgången – en aktie eller ett index. Till exempel kan en investerare betala en fast ränta till en part i gengäld för kapitaluppskattningen plus utdelning från av en pool av aktier.

Credit Default Swap (CDS)

En kredit default swap (CDS) består av ett avtal av en part att betala den förlorade principen och räntan på ett lån till CDS-köparen om en låntagare misslyckas betala på ett lån. Överdriven hävstång och dålig riskhantering på CDS-marknaden var en av de främsta orsakerna till finanskrisen 2008.

Swaps Sammanfattning

En finansiellt swap är ett derivatkontrakt där en part ”byter” kassaflödet eller värdet av en tillgång till en annan. Till exempel kan ett företag som betalar en rörlig räntesats byta ut sina räntebetalningar med ett annat företag som sedan betalar det första bolaget en fast ränta. Swappar kan också användas för att utbyta andra typer av värde eller risk som potentialen för kreditförluster i ett obligationslån.

A tactical play to political uncertainties

A tactical play to political uncertainties

ETF Securities Asset Allocation Research – A tactical play to political uncertainties

Highlights

  • For February, the tactical portfolio is reducing its allocation in US and French equities while overweighting Canada, India, Brazil, Russia and Turkey.
  • After two months underweighting most bonds except US investment grade, the tactical portfolio is taking a neutral position on rising interest rates and inflation expectations.
  • Within commodities, the portfolio tactically underweights nickel and tin, increasing allocation in corn and sugar while remaining neutral on energy and precious metals.

For February, the tactical portfolio is reducing its allocation in US and French equities while overweighting Canada, India, Brazil, Russia and Turkey.

After two months underweighting most bonds except US investment grade, the tactical portfolio is taking a neutral position on rising interest rates and inflation expectations.

Within commodities, the portfolio tactically underweights nickel and tin, increasing allocation in corn and sugar while remaining neutral on energy and precious metals.

Political uncertainties around the world are growing and may last longer than the market expects. While the divorce between the UK and the EU remains full of uncertainties, the German, French and Dutch elections are likely to add further uncertainty. Although we feel many elections pledges are unlikely to become a reality, the US may not be the trade partner the UK is seeking for as, since his inauguration, President Trump has been loosely delivering on what he has promised during his campaign. While market volatility has not picked-up yet, inflation is rising in the US, EU and UK, increasing the risk of central bank policy errors.

February 2017 positioning

Although very close to its lower band, the market volatility index (VIX) still stands between its historical average and its lower band, suggesting a more balanced tactical split between equities and bonds. The portfolio therefore has 45% in equities, 45% in bonds and 10% in commodities while its strategic benchmark holds 55% in equities, 35% in bonds and 10% in commodities.

Within the equity space, the CAPE (Cyclically Adjusted Price to Earning) valuation model suggests reducing allocation in the US and four European countries while overweighting Canada, Brazil, Russia, India and Turkey. European countries to underweight include France but also Italy, Denmark and, due to rising valuations, Sweden replacing the Netherlands this month. The US CAPE ratio is at its highest since December 2014, standing 47% above its 10-years median. For January positioning, the France CAPE ratio was also at its highest since 2007 before declining slightly this month. Among the countries at the other end of the spectrum, Brazil and Russia continue to show the largest differentials between their CAPE ratios and their respective 10-year medians, suggesting that these countries remain largely undervalued and justifying a tactical increase in their weights.

The below table highlights how our tactical positions have changed for the past three months compared to the strategic benchmark and our new positions for February.


(click to enlarge)

For November and December 2016, the bond model suggested to underweight most bond categories with the exception of US investment grade, as inflation expectations and interest rate expectations in the US and the EU were at a turning point. Last month, the model suggested returning to the strategic portfolio weights as both rates were rising in tandem. With the CDS (Credit Default Swap) of each bond hovering around its historical average, the tactical portfolio keeps a neutral position for February as well.

For commodities, the contrarian model is taking a complete shift for grains and softs from underweighting wheat, soybeans, cotton and coffee for January positioning to overweighting corn and sugar for February. While the model suggested underweighting copper, lead and overweighting zinc for January, it now suggests underweighting nickel and tin. The model has been tactically neutral on precious metals for the second consecutive month and shifts from overweight to neutral on energy.

Portfolio performance

The tactical portfolio still has the lowest level of volatility compared to a traditional balanced 60/40 portfolio, and the strategic benchmark, improving the Sharpe ratio by 35% on average to 0.44 compared to 0.37 for the 60/40 and 0.30 for the strategic portfolio.


(click to enlarge)

Whilst underperforming the 60/40 benchmark by 0.2%, the tactical portfolio outperforms its strategic benchmark by 0.6% per year since January 2005.


(click to enlarge)

With the exception of equities, each asset class in the tactical portfolio outperforms its counterpart in the 60/40 and strategic benchmarks. The bond component outperforms by 0.6% on average while the commodity component outperforms by 0.2%, illustrating the efficiency of our fundamental-based models in improving the risk/return profile of their respective asset class as well as the tactical portfolio.

In addition, the tactical portfolio provides higher protection from the downside risk with a maximum drawdown of -27.2% compared to -38.5% for the 60/40 and -39% for the strategic benchmark.

Finally, the portfolio recovers faster to its previous peak (2.42 years versus 3.25 years for both benchmarks).

Portfolio methodologies

Our strategic benchmark follows a long-only strategy with 60 investments across three asset classes: commodities (25), equities (28) and bonds (7). As illustrated below, the initial weights are based on the weighting methodology of:

The Bloomberg Commodity Index for commodities

The MSCI AC World Index for equities

The Barclays bond indices for bonds

(click to enlarge)

The strategic portfolio represents a balanced portfolio with 55%, 35% and 10% allocated in equities, bonds and commodities respectively. Every month, the strategic portfolio rebalances into the weights set by the above benchmarks.

Our tactical portfolio aims to outperform its strategic benchmark by applying fundamental-based models to reflect our expertise in each asset class and our views of the global economy. The tactical portfolio rebalances every month to a new set of weights determined by the models below:

The equity-bond relative trade model sets the weights at the asset class level between equities and bonds while commodities will remain at 10% all the time

The CAPE model sets the weight for equities

The bond model sets the weight for bonds1

The contrarian model sets the weight for commodities

Important Information

General

This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”).

The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.

This document is not, and under no circumstances is to be construed as, an advertisement or any other step in furtherance of a public offering of shares or securities in the United States or any province or territory thereof. Neither this document nor any copy hereof should be taken, transmitted or distributed (directly or indirectly) into the United States.

This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents.

ETFS UK is required by the FCA to clarify that it is not acting for you in any way in relation to the investment or investment activity to which this communication relates. In particular, ETFS UK will not provide any investment services to you and or advise you on the merits of, or make any recommendation to you in relation to, the terms of any transaction. No representative of ETFS UK is authorised to behave in any way which would lead you to believe otherwise. ETFS UK is not, therefore, responsible for providing you with the protections afforded to its clients and you should seek your own independent legal, investment and tax or other advice as you see fit.

Yielding towards the right bond model

Yielding towards the right bond model

Asset Allocation Research Yielding towards the right bond model

Highlights

  • With interest rates likely to rise in the US and inflation likely to increase both in the US and EU, it is time for investors to reduce their exposure to bonds.
  • However, bonds remain key in reducing investors’ portfolio risk. Our model based on fundamentals can help mitigate the upcoming downturn in the bond market.
  • Applying our model to a portfolio of bonds enhanced the Sharpe ratio to 1.61 compared to 1.51 for its benchmark by increasing return by 0.2% per year.

Download the complete report (.pdf)

As inflation increases on a global basis, central banks are likely to raise rates to keep inflation around their target. An increase in interest rates will, in turn, have a negative impact on the value of bonds. Record low interest rates in developed markets have favoured investments in riskier instruments as investors sought higher returns and income. An increase in interest rates is likely to be followed by a rotation to less risky assets as investors are by nature risk-averse, potentially moving towards more cash or sovereign bonds to the detriment of high yields.

In our tactical portfolio (and its latest update – Underweight US, Europe and precious metals), we use models to determine our positions in equities, bonds and commodities. While we have previously explained what goes into the equity and commodity models, this is our first note outlining in detail our bond model. We start with the indicators the model uses as trading signals, followed by the model mechanism and concluding with the portfolio of bonds and a performance analysis of the portfolio compared to its benchmark and the Bloomberg Barclays US Aggregate Bond Index since 2007.

Inflation expectations

Inflation can be measured in many ways. Inflation expectations measured by the 5yr 5yr forward inflation rate reflects the markets’ expectations on how central bank policies will impact inflation in the future. Technically, it represents the level of inflation expected over 5 years 5 years from now.

US and EU inflation expectations are highly correlated. A surge in inflation expectations like the one the market is currently witnessing means that inflation will likely increase and central banks will likely increase interest rates, undermining bonds.

In our bond model, we include the inflation expectations for both regions combined with their respective interest rate spreads (see chart below for the US).

Interest rate spread

The base rate is the rate at which central banks lend money to domestic banks. The 10yr forward rate is the rate at which investors are able to borrow money in 10 years from now, providing an indication on how the base rate should move in the future. With inflation expectation rates surging, the 10yr forward rates are rising, widening the spread with the base rates. This provides further certainty on an imminent rate hike, at least in the US, which would be prohibitive for US bonds.

(Click to enlarge)

Historically, the base rate moves most of the time in line with its 10yr forward rate if it does not catch it up. With the 10yr forward surging to 2.2% in the US while the base rates are currently at 0.95%, we will likely see the US Federal Reserve, increase its base rate, tightening the spreads.

In our model, we are using the spread between the 10yr forward rate and the base rate for the US and the EU combined with their respective inflation expectations as trading signals.

Credit default swap

A credit default swap (CDS) is a financial instrument that allows for the seller to transfer the credit exposure of a fixed income product to one or more parties. An increase in the value of the CDS indicates rising demand for insurance against a risk of default from the entity behind the underlying bond. It serves as a measure of the level of risk in the fixed income market.

(Click to enlarge)

Our analysis shows that there is a strong correlation between the quarterly return of bonds and the quarterly change of its respective CDS as illustrated above. In our bond model, we are taking into account the CDS level of each component of the portfolio relative to their respective first and second standard deviations above and below average.

The model mechanism

The model will tell us to overweight a bond if
– inflation expectations are at a turning point (switching from increasing to decreasing), and
– interest rate spreads are at a turning point (switching from increasing to decreasing), and
– the CDS of the bond is below its first or second standard deviation.

The model will tell us to underweight a bond if the opposite conditions to the above are aligned.

(Click to enlarge)

The above chart shows the portfolio historical positions in EU Sovereign bonds based on the model. While far from being perfect, it still manages in most occasions to signal the right changes ahead of price movements.

Performance and positioning

We created two diversified portfolios of bonds: our portfolio and its benchmark. Both have the same constituents as illustrated in the next table and rebalance on the first business day of every month. The benchmark rebalances back to its initial weights while the portfolio rebalances to a set of new weights based on the signals previously described.

(Click to enlarge)

For December, the model recommends to go underweight most of the components of the portfolio compared to the benchmark, except for US investment grade where the model recommends a neutral position. This results in a higher allocation to cash.

(Click to enlarge)

Applying the model to the portfolio of bonds shows that the portfolio outperforms its benchmark by 0.2% per year for the same level of volatility, improving the Sharpe ratio by 6.3% from 1.51 for the benchmark to 1.61.

(Click to enlarge)

We also note that the portfolio and its benchmark outperform the Bloomberg Barclays US Aggregate Bond Index (former Lehman Aggregate Bond Index) by at least 1.4%, reduce volatility and more than double the Sharpe ratio. This can be explained by a change in universe, weights and rebalancing methodology.

Important Information

General

This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”).

The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.

This document is not, and under no circumstances is to be construed as, an advertisement or any other step in furtherance of a public offering of shares or securities in the United States or any province or territory thereof. Neither this document nor any copy hereof should be taken, transmitted or distributed (directly or indirectly) into the United States.

This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents.

ETFS UK is required by the FCA to clarify that it is not acting for you in any way in relation to the investment or investment activity to which this communication relates. In particular, ETFS UK will not provide any investment services to you and or advise you on the merits of, or make any recommendation to you in relation to, the terms of any transaction. No representative of ETFS UK is authorised to behave in any way which would lead you to believe otherwise. ETFS UK is not, therefore, responsible for providing you with the protections afforded to its clients and you should seek your own independent legal, investment and tax or other advice as you see fit.

Oil needs more than a Venezuelan default

Oil needs more than a Venezuelan default

Oil needs more than a Venezuelan default Judging by CDS spreads, the market fears Venezuela is approaching default (at a 25% recovery, the market is pricing in a 98% probability of default!).

(Click to enlarge) Source: Bloomberg, ETF Securities

Surprisingly, despite the fact that Venezuela has not let the IMF in to the country to perform its annual assessment (Article IV consultation) since 2004, the Venezuelan government has managed to access the bond markets, with approximately US$100bn of debts outstanding. Worryingly, about a fifth of the government debt (US$21bn) is due within the next three years.

(Click to enlarge) Source: Bloomberg, ETF Securities

Venezuela controls the largest proved reserves of oil in the world (around 18%), and produces around 3% of global supplies (similar scale to Mexico). Petróleos de Venezuela (PDVSA), the state oil company is fully controlled by the government. They have a symbiotic relationship: the government relies on PDVSA for more than half of formal budget revenues and PDVSA is reliant on the government for access to the oil reserves and its relationships with creditor countries such as China. PDVSA has also issued bonds of its own, with total outstanding debts of US$50bn adding to the contingent obligations of the government.

Even though PDVSA and the government are two separate issuers and so PDVSA’s assets cannot be considered collateral by sovereign bondholders, PDVSA will likely face funding difficulties. Any attempt by the government to access more of the PDVSA’s revenues, will leave less resources for PDVSA’s bondholders and market access is likely to close very quickly.

A disruption to Venezuelan supply could tighten global oil markets. However, current global oversupply is around 2.3 million barrels per day according to International Energy Agency data. It is unlikely that all 2.6 million barrels per day of Venezuelan supply will be wiped out overnight. When Mexico defaulted in 1982, its oil production fell by only 8% and that took four years. In the initial phases of a default the Venezuelan government would likely want to work its oil assets even harder to finance itself. Therefore, we believe that to bring the global oil market into balance broader production cuts will be required by both OPEC and non-OPEC members.

For more information contact:

ETF Securities Research team
ETF Securities (UK) Limited
T +44 (0) 207 448 4336
E infoUK@etfsecurities.com

Important Information

This communication has been provided by ETF Securities (UK) Limited (”ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the ”FCA”).

When being made within Switzerland, this communication is for the exclusive use by ”Qualified Investors” (within the meaning of Article 10 of Section 3 of the Swiss Collective Investment Schemes Act (”CISA”)) and its circulation among the public is prohibited.

The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.

This document is not, and under no circumstances is to be construed as, an advertisement or any other step in furtherance of a public offering of shares or securities in the United States or any province or territory thereof. Neither this document nor any copy hereof should be taken, transmitted or distributed (directly or indirectly) into the United States.

This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective, officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents.

ETFS UK is required by the FCA to clarify that it is not acting for you in any way in relation to the investment or investment activity to which this communication relates. In particular, ETFS UK will not provide any investment services to you and or advise you on the merits of, or make any recommendation to you in relation to, the terms of any transaction.  No representative of ETFS UK is authorised to behave in any way which would lead you to believe otherwise. ETFS UK is not, therefore, responsible for providing you with the protections afforded to its clients and you should seek your own independent legal, investment and tax or other advice as you see fit.

The Master of Yields interrupted by negative sentiment

Midstream MLPs: The Master of Yields interrupted by negative sentiment

The Master of Yields interrupted by negative sentiment

Summary

•    Master limited partnership (MLP) distributions continued to grow in Q4 2015.

•    MLP valuations are attractive when assessed by appropriate valuation metrics.
•    Midstream MLPs’ revenues are more resilient to oil price fluctuations than upstream oil companies’ revenues.
•    Yet they are trading more like upstream oil companies. We believe there is potential for an upward correction as MLP resilience becomes apparent.

Download the complete report (.pdf)

The MLP structure remains intact

Master limited partnerships (MLPs) are tax exempt limited partnerships that are required to pass through majority of their earnings as distributions to investors. A confluence of factors from restrained capital market access, declining oil prices and fears of rising interest rates have seen the price of MLPs fall by more than 46%. We believe that this price reaction has been overdone. Negative sentiment over single MLPs such as Kinder Morgan, which became overleveraged after the additional purchase of 30% of Natural Gas Pipeline Company of America LLC, appear to have affected the sector at large. However, we see sustainable distributions and low valuations opening an attractive entry point to this sector.

For the purpose of this report MLPs refer to the 24 constituents (as on 12 Feb 2016) of the Solactive US energy infrastructure total return index.

Sustainable distributions

In their latest fourth quarter 2015 results MLPs have reported a 15% growth in quarterly distributions over the prior year allaying widespread concerns of distribution cuts.

(Click to enlarge) Although funds available for distribution have been on the decline since their peak in 2014, MLPs have been prudent in adjusting their capital budget by keeping distributable cash flow in sync with distributions paid as outlined by the weighted average coverage ratio of 1.27x.

(Click to enlarge)

Attractive valuations

When analysing distribution yields, we believe it’s vital not to view MLPs in isolation. We can draw a comparison to both utilities and real estate investment trusts (REITs). Utilities and MLPs are known to derive their primary source of earnings from services indelible to society that have high barriers to entry. In fact utilities were the original owners of many of the assets from which today’s MLPs are formed. Real estate investment trusts (REITs) and MLPs can be linked by their ownership of tangible, long lived assets ruled by underlying contracts that provide a stable income stream. MLPs also have a similar structure to REITs that escape being taxed at a corporate level. Midstream MLPs currently offer a 6% distribution yield, attractive relative to history of earnings yields of similar assets. The current low interest rate environment has investors searching for yield from non traditional sources, supporting the case for MLPs.

(Click to enlarge) Given that MLPs pay a vast percentage of their income in distributions and rely on debt and equity capital markets to fund capital growth, we use valuation metrics such as enterprise value (EV) to earnings before interest tax depreciation and amortisation (EBITDA) multiples, in tandem with net debt to EBITDA rather than traditional price to earnings and price to book ratios. Since the latter half of 2014, MLPs were cautious not to raise debt in large proportions as they did in the prior valuation peaks. In the last valuation peak, MLPs did not leverage as high as in previous peaks because funding costs were higher and they had less capex need. While it has not yet reached the trough of 7x last seen in the financial crisis, EV/EBITDA is currently at 13.5x below its median of 14x. The price to cash flow from operations multiple for MLPs at 7.8x is trading at a discount to the 10-year average of 12x, also highlighting MLP’s attractive valuation.

(Click to enlarge) Midstream MLPs derive their revenues from the volume and not price of the product being transported. MLP revenues are far less correlated to oil prices than oil companies. MLP revenues rose by 2.4% in 2015 while revenues for the top 30 oil companies (by market capitalisation) fell by 5%.

Despite MLPs’ greater revenue resilience to oil price, they have been trading more like upstream oil companies and we believe that there is potential for an upward correction in their price when this becomes more apparent to the market.

(Click to enlarge) Correlation of MLPs with oil, natural gas and the US benchmark S&P 500 index have been rising this year. The correlation of MLPs with the S&P 500 index has risen to 0.8. This underscores the effect of negative sentiment emanating from the global equity market rout on MLPs and not just weak oil prices. MLPs are likely to remain correlated to the oil price and a potential rebound in oil prices could play in MLP’s favour.

(Click to enlarge) Credit default swap (CDS) spreads that measure the cost of protecting MLPs from default have risen astronomically compared with energy companies and have surpassed levels last seen in the 2008 financial crisis. What stands out from the historical data for CDS spreads is that upstream MLPs (compiled from the weighted average of the top 20 upstream MLPs) are at a greater risk of default and are denting sentiment among midstream MLPs. It’s imperative to distinguish between the energy silos as they carry different cash flow dynamics. While upstream MLPs are directly involved in exploration and production of oil and natural gas products, midstream MLPs differ from them as they generate a significant amount of fee based revenue tied to storage and transportation. In fact the vast majority of distribution cuts that occurred in Q4 2015 were from upstream MLPs and we have seen no distribution cuts from our current midstream MLP universe. Valuations are treating upstream and midstream MLPs similarly, while in reality their default risks, are inherently different, a result of their different business models.

(Click to enlarge)

Conclusion

In light of the above discussion we believe midstream MLPs are trading at levels that reflect the distress in the energy sector. By virtue of the resilience of their revenue streams, current valuations on EV/EBITDA basis and managed debt levels, midstream MLPs are well positioned to appreciate given a turnaround in stressed capital markets and sentiment.

For more information contact:

ETF Securities Research team
ETF Securities (UK) Limited
T +44 (0) 207 448 4336
E infoUK@etfsecurities.com

Important Information

This communication has been provided by ETF Securities (UK) Limited (”ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the ”FCA”).

When being made within Switzerland, this communication is for the exclusive use by ”Qualified Investors” (within the meaning of Article 10 of Section 3 of the Swiss Collective Investment Schemes Act (”CISA”)) and its circulation among the public is prohibited.

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