Australian Fixed Income
Australian Fixed Income

In September we discussed how investing in International equities can provide better portfolio diversification and a more sustainable risk/return profile when compared to investing solely in Australian equities.

This month, we focus on the role that fixed income can play in your portfolio, in providing certainty and predictable income streams from the defensive parts of your portfolio. Fixed income plays a valuable defensive role in a portfolio, typically providing greater capital stability than equities, property or other growth investments.

This is particularly pertinent given last month’s announcement by Telstra that it was cutting its dividend by 29% and consequent share price fall, which highlighted a key difference between equities and bonds – dividends are discretionary and can be cut, causing volatility in prices, while coupons are locked-in, meaning bond returns are predictable.

Australian retail investors have become more risk adverse, keeping their money in the bank. Indicative of this, post-Global Financial Crisis (GFC) balances in household bank deposits were $845 billion as at June 2017 (APRA monthly banking stats), which is ten times higher than it was pre-GFC.  Since the GFC 24% of Self-Managed Superannuation Funds (SMSF) assets in cash and term deposits ($160 billion) is testament to this and highlights that investors need certainty and predictability from the defensive part of their portfolios.

Australian retail investors have traditionally not invested in fixed income.

Until recently, only large institutional investors really had access to all of the Australian fixed income market. Over the last 20 years or so, the big change – globally as well as here in Australia – has been the move to ‘liability-driven’ investing. In the mid-1990s, UK insurers and pension schemes realised that they had large asset-liability mismatches: Boots’ pension plan sold out of its equities and moved entirely into fixed income because fixed income allowed them to more accurately match assets against outgoing liabilities (payments to pension scheme members).

This is not very different to everyday investors wanting to match their outgoings, in terms of living expenses, or school fees, with their income and principal payments. ‘Outcomebased’ investing means you know on the day you invest, exactly what you’ll receive from your investment. Individual bonds, be they Commonwealth Government or corporate are the only securities that allow you to do this.

At the end of March 2017, Australia’s 590,742 self-managed super funds (SMSFs) held about 37% of their assets in listed shares, around 24% in cash and term deposits and 33% in property. Investments in fixed income securities amounted to a little over 1% of SMSFs’ assets.


 

Limited Appetite and Opportunity to Invest in Bonds

The tendency of Australian retail investors to stay away from fixed income is the result of various factors:

Firstly, most Australian investors have been firmly entrenched in Australian equities and property as well-understood asset classes for many years. Following the GFC, bank deposits and term deposits – themselves
a fixed income alternative – were offering very attractive rates, and carried the security of a government guarantee (for amounts under $250,000).

Most importantly however, was the fact that government and corporate bonds, the main fixed income securities simply weren’t widely available to retail investors. The Australian bond market was dominated by institutional investors and banks trading between themselves in the professional market in parcel sizes of typically at least $500,000 – far too large a sum for most retail investors and SMSFs.

Until recently, Australian retail investors and SMSFs have not had the opportunity to invest in bonds. They were generally not available to trade on the ASX like shares, and bonds were not available on wrap platforms. In addition, prior to the GFC, there were 20 plus years of bull markets in equities and many investors may not have felt the need to invest in fixed income securities.

A lack of awareness, education and opportunity made sure bonds remained an institutional investment while term deposits delivered good risk/returns post-GFC and they became the fixed income choice for many investors. However, this is changing, particularly as term deposit rates have tracked down with falling interest rates to new all-time lows.

New Developments Make Investing in Bonds more Accessible

Various developments over the past few years have made it a lot easier for SMSFs and retail investors to access fixed income securities:

  • The ASX introduced exchange-traded Australian Government Bonds (AGBs) in 2012, which are traded on ASX and can be bought in $100 units.

  • This was closely followed by fixed income exchange-traded funds (ETFs), which enable investors to invest in portfolios of fixed income securities based on an underlying bond index.

  • In 2015, XTBs (Exchange Traded Bond units) were introduced over individual corporate bonds from the top 50 ASX listed companies. Like AGBs and ETFs, they are traded on ASX. Unlike the institutional market, there is no minimum investment, so XTBs may be accessed by all investors and SMSFs on the ASX in $100 lots, thereby enabling investors to build diversified portfolios of corporate bond exposures.

Corporate bonds: Key features

The key features of senior corporate bonds from investment grade issuers are as follows:

  • A corporate bond is a debt security – a loan to the company by you, the investor.

  • When you loan someone money, you expect to be paid back along with interest. The company cannot change the interest amount (the bond’s coupon), or the payment dates.

  • The face value of the bond will be repaid when it matures and the company can’t change the maturity date.

  • On the day you buy a fixed-rate corporate bond, the return you will receive (yield to maturity) is 100% known to you. This is due to the fixed nature of the coupon & principal payments and dates.

  • Only a default by the company can change this outcome (or if you sell prior to maturity).

Bonds are very different to equities

It’s important to keep in mind that corporate bonds are very different to the shares issued by the same company. The seniority of the bonds and the fact the company has an obligation to pay its senior bondholders on time is at the core of why bonds are stable.

The Board of a Company has considerable latitude to vary dividends or, indeed, not pay them at all. Also shares are perpetual, so there is no ‘principal’ to be paid back, you own part of the company as a shareholder, so you enjoy (or suffer) the ups and downs that come with that. A bondholder is owed money by the company – principal plus interest on hard fixed dates – period, or the company is in default.

Volatility: Share price vs Bond price

The factors that determine share prices include everything that can possibly impact the value of the business, encompassing every investors’ perceptions or opinions on the business, and their view on future earnings. Bond prices represent the present day value of the coupons and principal, taking account of the risk the issuer will not meet these payment obligations (credit risk).

Recently we have seen a number of examples of the share price of a leading Australian company falling quite sharply, with little or no movement in their bond price.

These situations are essentially very simple to explain:

  • Equity investors have changed their view on the earnings outlook, dividend paying ability and value of the business.

  • Bond investors haven’t changed their view on the company’s ability to keep paying the interest and principal.

In the case of Telstra, the Board recently resolved to lower the dividend payout ratio on their ordinary shares to between 70% to 90% of earnings, down from the previously unsustainable level of 100% of earnings. The Company decided it needed to retain more of its earnings after reviewing its long term capital expenditure requirements as it attempts to fill the hole in earnings left by the nbn.

The news of the dividend cut has pushed TLS shares to five year lows, while the price of the Telstra corporate bonds has remained stable.


Not All Bonds Are Created Equal

Fixed income generally provides investors with more secure and capital stable investments than equity, hybrids, property and other growth assets. But not all companies are equal when it comes to the ability to keep paying the interest and principal on their bonds. It all comes down to the capital structure.

The credit ratings by major ratings agencies such as Standard & Poor’s, Moody’s and Fitch give some indication of the credit risk of that issuer. Stronger credit ratings for banks and the largest ASX listed companies indicate they’re a safer bet. Lower ratings, but still investment grade (BBB- or above) indicate greater risk for which you’ll receive a greater return.

You can also get a sense of this risk in the yield-to-maturity of same tenor (time to maturity) corporate bonds from one company versus another. In general, the company with the higher credit risk will trade at a higher yield-to-maturity (lower price) than the lower risk issuer.

Also not all securities that are issued by the same company are equal when it comes to credit risk. Many companies, banks in particular have other securities that sit between senior debt and shares. In the event a company gets into financial trouble, holders of the senior bonds will be paid out first. This occurs before holders of subordinated debt and is followed by the various forms of hybrids and preference shares with ordinary shareholders paid last. Of course, there may be nothing left after the senior bondholders get paid.

The higher in the capital structure, the lower the risk, as you’re higher in the queue if there’s a default. This lower risk means lower returns, but it also means lower capital volatility. The lower in the capital structure, the greater the return and the risk and the volatility of prices.


 

What is the likelihood of a corporate bond credit default?

Corporate bonds are generally stable but an investor needs to consider the risk of a default by the Company on its interest payment. While it’s not at all common for the investment grade issuers in the top ASX 100 companies, it does happen and it can’t be ignored as a risk.

Standard & Poors publishes default probability stats on a regular basis. They are based on actual defaults globally of both investment grade and non-investment grade issuers. For example, the default probability they published for 3-year investment grade bonds was less than 0.3%. Longer dated bonds have a higher probability because the risk any company could collapse increases as you move further into the future.

In Australia, the corporate bond market is still relatively under-developed compared with the US and over-concentrated in very high-quality names. Defaults by investment grade issuers have been rare in Australia and we simply don’t have the same well-developed sub-investment grade, or high-yield bond market as the US.

Over the last 30 years, Babcock & Brown and Pasminco are the only 2 companies that defaulted and whose corporate bonds started life as investment grade (i.e. with a credit rating of BBB- or better).

The high profile defaults of businesses that took place in the wake of the GFC such as Storm, Gunns,  Timbercorp did not have a credit ratings or involve bond holders.


 

Interest rate changes and price sensitivity

Fixed coupon bonds are sensitive to interest rate movements - they generally fall in price when interest rates rise, and increase in price when rates fall. But their degree of sensitivity may not be as great as investors may think, given their experience with the volatility of equities and hybrids. With interest rates at all-time lows and likely moving higher in the medium term, investors need to understand how sensitive fixed coupon bonds are to changes in interest rates.

The following table shows the price sensitivity of fixed coupon bonds for given interest rate movements. It also shows the price sensitivity for a number of different time to maturity (tenor) to demonstrate that, all else being equal, longer-dated bonds are more sensitive to interest rate changes than shorter-dated bonds.

Rate Change 1 Year ($) 3 Year ($) 5 Year ($) 7 Year ($)
-1.00% 100.99 102.90 104.74 106.50
-0.75% 100.74 102.16 103.53 104.83
-0.50% 100.49 101.44 102.34 103.19
-0.25% 100.24 100.72 101.16 101.58
0.00% 100.00 100.00 100.00 100.00
0.25% 99.76 99.29 98.85 98.45
0.50% 99.51 98.59 97.72 96.92
0.75% 99.27 97.89 96.61 95.42
1.00% 99.03 97.20 95.51 93.95
1.25% 98.79 96.51 94.42 92.50
1.50% 98.55 95.83 93.35 91.08

As mentioned earlier, when rates fall, bond prices rise, and vice versa. As a guide most of the current range of fixed coupon corporate bonds are between 3 to 5-year time to maturity.

All else being equal, a $100 3-year corporate bond will fall to $99.29 or $98.59 if the RBA lifted rates by 25bps or 50bps respectively. In recent years, the RBA has moved rates in increments of 25bps, so it would take a fourfold increase in rates to cause a three-year bond trading at $100 to fall to $97.20.

Rates would need to increase by more than 1.5% to cause the 3-year bond price to fall from $100 to $95. The longer dated bonds have greater price sensitivity, a 1.5% increase in rates will cause the price of the 7-year bond to fall to $91.08.

The chart below plots the data from the table above in graphical format.




Conclusion

The current global economic environment is unusual in that it includes low nominal interest rates and little inflationary pressures, to date, resulting in low real interest rates. In such an environment, every percentage point of investment return really matters.

A 1% gain or loss matters less when official interest rates and major government bond yields are about 5-6%. When they are 2% or less, as is the case now, a 1% change is far more significant.

The capital stability that comes from investment grade bonds is a much more important element in investment. Relative to equities, hybrids and other growth assets, bonds offer a high degree of capital stability as well as highly predictable income.

With the rates on term deposits at all-time lows and investors concerned with capital protection, there is a growing need for higher yielding fixed income options, such as corporate bonds.

As of the end of August 2017, two-year term deposits of $50,000 were paying on average around 2.50%. In contrast, the yields available on investment grade corporate bonds, via XTBs, ranged from 2.0% to 4.0%, providing up to one and a half percentage point’s uplift in yields over term deposits.

Should you wish to discuss your SMSF or Investment Portfolio and the options available please contact your Patersons Wealth Adviser