Managing duration risk through active security selection was a key strategy in our model portfolio year-end performance. The BondAdviser Income Opportunities Portfolio returned 7.75% (3.24% above benchmark – RBA Cash Rate + 3.00% p.a.) and the BondAdviser Income Plus Portfolio returned 4.27% (1.26% above benchmark – RBA Cash Rate + 1.50% p.a.) for the year ended 30 June 2017. The re-emergence of inflation expectations and pro-growth policy promises out of the US drove equity markets higher over the year while the reversal of long term interest rates drove bond prices lower. For the year ended 30 June 2017, the ASX200 Accumulation Index rose 14.1% while the AusBond Composite Index finished broadly unchanged (0.3%). However, the AusBond Credit Index increased modestly by 2.8% illustrating credit fundamentals remain intact and rather, poor performance was primarily a function of a higher and steeper yield curve. To put this in perspective, the Australia 10-Year Treasury Yield rose from ~1.95% to ~2.60% while the RBA cash rate was cut from 1.75% to 1.50%. The RBA will meet tomorrow for its first meeting of the new financial year with futures markets pricing in no change to the cash rate for the 10th consecutive meeting. As at 30 June 2017, the ASX 30 Day Interbank Cash Rate Futures July 2017 contract was trading at 98.505, indicating a 2% expectation of an interest rate decrease to 1.25% at tomorrow’s RBA board meeting.

Chart 1: Bloomberg AUSBond Composite Index (Monthly) Chart 2: Bonds vs Equities 2016/2017 (Monthly) Chart 3: Term Deposit Review – May

European Banks In early June, Spanish bank Banco Popular marked the first major capital bail-in since the introduction of the Basel III in 2011. After the European Central Bank (ECB) deemed Banco Popular was “failing or likely to fail”, the Single Resolution Board (the European authority for dealing with failing banks) swiftly cancelled all existing shares and Tier 1 capital instruments in an unprecedented move. The final outcome was a rally in Banco Popular’s senior bonds and its remaining equity (Tier 2 instruments were converted) being sold to Santander for just €1. While this demonstrated the effectiveness of modern banking regulation (namely the avoidance of tax payer bail outs), large banks absorbing failing small banks was common during the Global Financial Crisis (GFC). For this reason, the outcome would have been more challenging if a systematically important bank failed or the economic environment was less forgiving. This was followed by the near-failure of two Italian banks (Veneto Banca and Banca Popolare di Vicenza) last week. As both banks were considered non-systemic, the Special Resolution Board (SRB) deemed that their failure would not have significant ramifications for financial stability. However, due to a last-minute government rescue package these banks avoided the resolution process highlighting the clear inconsistencies around bank interventions. Though these circumstances render no comparison to the Australian banking environment (significantly stronger), it illustrates the strengths/weaknesses of the current regulatory landscape and has implications for our broader credit strategy. We will address this in depth in our Monthly Review scheduled to be released this week.

Insurance Update Following Suncorp’s initial announcement in February 2017, the group launched a takeover bid for NZ insurer Tower Limited for NZ$236mn. The transaction will be conducted by Suncorp’s NZ subsidiary, Vero Insurance which currently owns 20% of Tower’s outstanding shares. Management signalled the takeover will be funded internally and no additional capital will be required. The transaction is broadly neutral from a credit perspective but highlights the market share concentration in the NZ insurance industry. On a pro-forma basis, IAG and Suncorp will collectively own ~75-80% of the NZ market. While economic deterioration in NZ is not a base-case scenario, this exposure is worth noting. IAG advised that its insurance reserve releases for FY17 will be revised upwards from 2% to 5% of net earned premiums (NEP). This will naturally reduce IAG’s net incurred claims expense and hence, the group’s guided its insurance trading margin to 13.5-15% from 10.5%-12.5%. While long-term expectations remain at around 1% of its NEP, positive assumption revisions for insurance reserve releases has been a common trend among insurers.

Crown Resorts Last week, Crown Resorts’ staff detained in China were sentenced for gambling corruption crimes. Five employees (including the head of international high roller operations) were given a 10-month sentence while the remaining eleven staff received 9-months. The sentencing included a combined fine of $1.67 million which the group indicated it will pay collectively. While the immediate credit impact is immaterial, domestic authorities have signalled their concerns and the group could face reviews into its state licenses. Although it is too early to speculate if there will be any action from authorities, there is now further uncertainty around the group’s high-margin VIP business which experienced a 45% decline in turnover for the six months ended 31 December 2016. We will continue to monitor Crown’s regulatory risk and the subsequent credit impact as more information comes to light. The group advised it has suspended the buy-back of its Subordinated Notes (ASX: CWNHA) until the day after it releases its full year results (FY17) scheduled for the 4th of August 2017. Crown has repurchased ~$126 million of the notes and ~$406 million remain outstanding which we expect will be difficult to attain through on-market repurchasing.