BROUGHT TO YOU BY rethinking income & diversification
BROUGHT TO YOU BY
rethinking income &
diversification
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C O N T E N T S
Rethinking income and diversification
Tapping into the world of bonds
How are they traded?
Are bonds the same as hybrids?
Risks associated with investing in bonds
Mitigating the risks
Comparing income sources
Why invest in bonds?
What is the best way to invest in bonds?
Conclusion
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I N T R O D U C T I O N
Market swings are now a normal part of investing. Hairy curve
ball moments, including central bank actions and geopolitical
concerns, are factors which continue to rattle markets everywhere.
On the local front, a low cash rate looks like it’s here to stay.
Investors are now realising the importance of finding investment
options which offer good, consistent income.
Fixed-income allocations like bonds are one defensive strategy
investors can use in these uncertain times. If you do the right
research, it’s possible to find bonds that offer long-term returns
with lower risk than higher-yielding investment options.
Getting a better understanding on how bonds work gives
investors another avenue to access attractive income and to
build a diversified investment plan.
This eBook will outline tips and traps involved when investing in
bonds and will help you take the right approach on your search
for great returns.
Yours sincerely,
Peter Switzer
Leading financial commentator and founder of the Switzer Group
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Rethinking income & diversification
Market volatility is now a normal part of investing.
Central bank actions, geopolitical risks and commodity
price swings continue to hit markets around the world.
At the same time, investors confront a low interest
rate world. The recent decision by the Reserve Bank
of Australia to cut rates another 25 basis points to the
now cash rate of 1.75% will only mean lower rates for
longer. Adding to this is the recent reduction in dividend
payments from the banks who have historically shown
growing dividend payments.
Against this background, it will be increasingly difficult
for investors to access investment options that offer
good consistent income.
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tapping into the world of bonds
Most investors think of term deposits as part of their
fixed-income allocation. However, with rates at all-time
lows, the average 3 year term deposit is now offering
less than 3% p.a. For shorter time periods the interest
income being offered is around 2% p.a. Once you
factor inflation into your return the real value of your
investment after the period of the term deposit will
be much less than the interest rate offered. Also you
can’t access your investment without penalties until
the term is up. What you really should be considering
are bond investments which give you flexibility to
invest and redeem your money frequently and are
aiming to achieve returns greater than term deposit
rates. Remember though, with higher expected returns
comes higher expected risk, therefore you need to look
for bonds that offer lower potential risks while still
offering good long-term income returns.
AVERAGE TERM DEPOSIT RATES & P.A.Source: www.Ratecity.com.au as at 4th May 2016
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It’s time investors re-think their fixed-income exposure.
Investing in bonds can provide investors with the
opportunity to access income without the risks that
comes with other high-yield investments.
A bond basically works like this. Investors lend money
to a government or company at an agreed interest
rate for a certain period. In return, the borrower, the
government or corporate, agrees to pay the lender
interest at regular intervals and repay their loan at the
end of the term.
This means that bonds pay regular income payments
and most have redeemable dates, which ensures your
investment is paid back in full.
Bonds can pay floating, fixed or inflation-adjusted
income, usually on a monthly, quarterly or semi-annual
time period.
Let’s look at bonds in further detail.
Each bond is assigned a credit risk, i.e. the risk the
bond is not able to pay income and/or pay the initial
investment amount at the end of its term.
For example, NSW government issued bonds have the
best possible credit rating - AAA. This is because the
bond is backed by a government (we are not talking
about the Greek government here!). Then of course,
it is worthwhile to consider other classes of bonds
that may not be rated AAA but offer higher returns.
The following graph illustrates the Australian and US
government bonds against AAA, BBB and BB rated
bonds issued by corporations.
AAA TO BB SOVERIEGN & CORPORATE YIELD CURVESSource: Bloomberg
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The above chart shows how a bond with a lower
credit rating, e.g. BB, has a higher expected return
no matter what the term in years. However as we
have stated, this also comes with higher expected
risk expectations. AAA rated sovereign bonds, which
are basically federal or state government bonds, offer
the lowest expected return and also have the lowest
expected risk of default.
The AAA rating implies there is an extremely low
probability income payments will not be made or the
principal is paid at the end of the bonds term. At the
other end of the spectrum there could be a technology
start-up company issuing bonds and given the high
risk nature of the business the credit rating assigned
could be quite low, e.g. a B rating. Then, of course,
in the middle of the spectrum we have bonds issued
by all manner of businesses from medical through
utilities to food vending businesses. These are rated
BB.
Relative to the NSW government bond a B rated
technology company bond would be perceived as more
risky. So why would an investor buy the technology
company issued bond?
The income paid by this bond will be higher than the
NSW government bond. This higher yield is meant to
compensate the investor for taking on greater risk.
The below chart shows the expected return and risk for
each of the different types of credit ratings given by a
group such as Standard and Poors.
Investing in the highest credit rated bonds will give you
the lowest return relative to a Not Rated bond, however
the latter offers potentially much higher risk to your
initial investment and income payments. It should be
noted groups such as Standard & Poors don’t always
get their credit ratings right, hence why many bond
funds will invest in a broad spectrum on credit rated
bonds based on their own analysis of the potential
credit risk.
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The following chart sourced from JPMorgan shows
the default rate for High Yield Bonds (lower credit
rated and not rated bonds) and for Leveraged Loans
(secured loans to medium sized companies are called
Leveraged Loans in the US) in the United States over
the past 16 years. A payment default is the worst thing
that can happen to you when you buy a bond. That’s
why it is of paramount importance to understand and
examine all the cash flows of the borrower, to assess
and understand the credit risk attaching to a bond or a
loan before making an investment decision. Assessing
credit risk is a complex and difficult task that should
be performed by an expert.
This chart illustrates that from time to time default
rates rise and fall, times can get tough. This is why a
successful bond investor will always apply a worst case
stress test to every bond investment before making a
purchase decision. Only after applying the stress test
can an investor be confident of receiving back 100%
of a bonds principal and interest obligations, even in
the worst case economic scenario.
As the chart shows, defaults peaked for these two
bond types in around December 2009 at the height of
the GFC. It is during these events like December 2009
that you want to make sure the bond you have invested
in doesn’t default. Currently the defaults rates are
approximately 3.68% and 2.15% respectively.
Source: J.P. Morgan
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how are they traded?
The vast majority of bonds are not traded on the
Australian Securities Exchange (ASX) nor any global
stock exchange. They are traded on what is called the
“over the counter” market. This is a market where
bonds are traded directly between bond brokers,
fund managers and other bond intermediaries. Retail
investors can access some bonds however in large
dollar multiples and normally through a bond broker,
e.g. FIIG. Only recently have some bonds been made
available via the ASX.
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so, are bonds the same as hybrids?
Bonds are not the same as hybrids. As the name
implies, hybrids are an investment structure that
exhibits the features of both an equity and bond
investment. Recently, Australia has seen a number
of hybrids issued, in particular by the Australian
banks. While they offer potential good income returns,
because they are listed and can be traded on the
ASX their value is based on equity and bond market
conditions and the value of the underlying issuers, i.e.
the Australian bank that issued it.
While some of the hybrids available are offering very
attractive returns, the capital value of these hybrids
can fluctuate due to movement of the underlying
share price of the issuer. Using Crown as an example,
when the Crown share price goes down, there is a
high probability the Crown hybrid will also move down
in value and vice versa. This is due to the potential
convertibility of the hybrid to a share so it makes
sense its value would be affected by movements in
the underlying share price. The chart below shows the
historical price relationship between the shares and
hybrids issued by Crown.
CROWN SHARE PRICE VS HYBRID PRICESource: Bloomberg
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what are the risks associated with investing in bonds?
Like any investment there are risks. Investors need
to consider three main risks when investing in bonds
which are credit, market and liquidity risks.
Credit RiskAs highlighted earlier in the report, credit risks are
the risk income payments will not be made and the
issuer of the bond will default and the investor could
potentially lose all their investment. Bonds are usually
given a credit rating by groups such as Standard and
Poors and/or Moodys. These groups provide a scale
which goes from AAA rated bonds, i.e. the lowest credit
risk, to Not Rated meaning the highest possible credit
risk.
Market RiskAs the name suggests, market risk is based on the
overall investment market activity, e.g. how the recent
global uncertainty about economic growth impacts
the pricing of investments such as bonds. This means
when bonds are valued each day they will reflect the
investment market uncertainty, so if an investor was to
sell a bond during periods of high investment market
uncertainty there is a high probability they will get a
lower price than if they sold when conditions were less
uncertain. This risk also applies to the equity markets.
Liquidity RiskThis risk is tied to market risk in that during high
periods of uncertainty, like we experienced during the
global financial crisis, they may be less buyers than
sellers of investments which means firstly, it could
take longer to sell an investment, and secondly, the
selling price could be much lower due to there being
less buyers. This risk also applies to equity markets,
in particular, the smaller and micro-cap stocks that
aren’t usually traded that much in normal market
conditions.
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mitigating the risks
this doesn’t mean just investing in the best credit rated
bonds such as government bonds. There are thousands
of bonds issued every year that offer different credit
ratings and different income payments. In some cases
a higher credit risk bond may be a better investment
than a lower credit risk one.
(i) Bond Selection:
(i i) Diversi f ication:
(iv) Volati l i ty Management:
( i i i) Outsourcing:
in the value of a managed bond investment fund
can be a good indicator of an investment manager’s
experience and success in selecting bond investments
with a reliable Return to Risk ratio. If a bond fund
manager is able to produce relatively high returns
over a long period of time (say 5 to 10 years) with
low volatility in those returns then this indicates the
manager knows the market and has been selecting
the best bond investments to control risk and deliver a
stable return over time.
to experienced investment managers. Bond investment
requires a detailed knowledge of the mechanics behind
their pricing and how credit risk is determined. This
comes with extensive practical market experience.
Experience also helps in cross checking the credit risk
rating the credit rating groups give, as in many cases,
the rating is not truly reflective of the bond. This was
particularly highlighted during the global financial
crisis, which revealed that the credit rating groups were
wrong with their assessment of these bonds. Therefore
you need an experienced bond manager to make sure
the bonds will pay income and have a low probability
of not paying the principal investment back.
spreading your bond investments across a number of
bond issuers and sectors.
As we have stated, all investments come with some
sort of risk, however, these risks can be reduced
through careful;
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comparing income sources
Shares pay income, so why wouldn’t I just invest within
shares, or with a share fund manager?
This is correct. Here in Australia, we have been fortunate
to have a tax system that favours the investor, i.e.
imputation credits. The Australian banks in particular
provided good income distributions over the years,
however there are many companies that don’t.
Australian companies paying good dividends have
played an important role in the portfolios of yield-
hungry investors. However, with the patchy growth
outlook, many of these companies will struggle
to boost earnings, which will affect their ability to
maintain their dividends. While BHP Billiton was not
considered an income stock, its decision to cut its
dividend in over 30 years served to highlight that this
may be a reality for many companies.
It’s important to note that shares, like bonds, are
exposed to both market and liquidity risk in times of
uncertainty.
As an investor, selection, diversification and the
outsourcing to an experienced investment manager
are important to minimise these risks.
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why then invest in bonds?
Look at the chart below. Remember that not all shares
pay the income levels banks and Telstra do and that
bonds only pay income.
We can look at the period from mid 2004 to late 2007
as an example. The share index during this period rose
rapidly while the bond index had a steady rise. Now look
at the period from late 2007 to early 2009, a massive
fall in the share index occurred. To the present day
the share index has risen again while the bond index
continued its steady rise. Noting as well the numbers
are based on indexes that are made up of hundreds of
shares and bonds, so if you were able to pull out only
the best performing shares and bonds the outcome
would be very different, however, if you were able to do
that you wouldn’t be reading this eBook, you would be
retired on a beach in the Caribbean!
Having an investment portfolio that contains both
shares and bonds would be a prudent investment
decision. As the chart below shows, while shares and
bonds can perform the same during periods of extreme
investment market uncertainty they can perform very
differently during other periods. It is during these
periods where the true benefits of diversification are
achieved by holding both shares and bonds.
BLOOMBERG AUSTRALIAN MASTER BOND INDEX VS ASX S&P 200 INDEX
Source: Bloomberg
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what is the best way to invest in bonds?
There are two main ways to invest in bonds:
The direct approach
Managed fund
As mentioned above you could purchase individual
bonds via a bond broker/intermediary. If you have
sufficient investment funds you could purchase a
number of different bonds to gain diversification
however you may be limited to the sectors you could
access and therefore the potential income. You may
also end up with a country bias in your holdings, i.e.
Australia. Given the vast majority of bonds are issued
overseas this bias would not necessarily be a good
thing from a complete portfolio perspective.
However bear in mind that successfully selecting
a single bond investment requires a high level of
knowledge and market experience. Prices on single
securities can differ in over the counter markets from
buyer to buyer and no two bonds are the same.
Investors can access an experienced bond investment
manager who will have a portfolio of bonds diversified
across the credit risk spectrum, by sector and by
country. The bond investment manager will manage
this fund daily and some funds will focus on just the
highest credit rated bonds, others the lowest and some
funds across the whole spectrum. Each therefore will
have different income and return objectives.
Given the benefits that can be received from aggregated
buying power and specialist experience, a good bond
fund manager will usually deliver returns net of fees
that are not achievable by individual investors investing
directly.
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CONCLUSION
With interest rates set to stay lower for longer and
a benign growth outlook, it will challenge investors
to rethink their approach to where they can source
income. While equities will always play an important
role in an investor’s portfolio, it’s time investors look to
diversify their sources of income beyond term deposits
and income stocks such as banks and Telstra. Bonds
offer investors sustainable sources of income but also
the ability to achieve a truly diversified portfolio.
D I S C L A I M E R
Whilst the information and statistics contained in this article are believed to be correct at the time of publishing, they are indicative only and do not constitute legal or financial advice. Investors should seek independent financial and legal advice before deciding whether any
investment is right for them.