A bond for all ages

PORTFOLIO POINT: You’re never too young to own bonds. It’s just a matter of picking the best option to suit your risk profile.

There are a couple of common misconceptions about bonds: that they are only for retirees, and that the interest payments are too low for other investors seeking higher return (thus higher risk) assets. Both are untrue.

Bonds are great investments for investors of all ages, not to mention corporations, superannuation funds, governments and local councils, charities and other not-for-profits, and really just about any entity with cash to invest.

Cash is all too often invested in bank accounts of all descriptions and sometimes forgotten in accounts earning very little. More motivated investors invest in managed funds to try and earn more but, as I explained in my recent article The problem with managed funds they can be risky and you don’t have the control of a direct investment.

Last week’s cut to the cash rate and the expected future 90-day Bank Bill Swap Rate (Figure 1) mean that the market expects further cash rate cuts of around 50bps, and returns on cash investments such as term deposit rates should continue to decline. There’s really no better time to start investing in bonds, no matter what your age or risk/return requirements.

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Aged-based strategies

A very general rule of thumb for investors when deciding how much of their portfolio to allocate to bonds is to “own your age in bonds”. Young investors have time to recover from shocks to the market, whereas the closer you get to retirement, the less time you have to rebuild your portfolio. While the fixed-income asset class is generally less risky than equities, strategies based on age mean that younger investors, even within the lower-risk asset class of fixed-income, can afford to have a greater proportion of their investment in high-yielding fixed-income securities.

Bonds for children

Most bonds bought for children will be with a view to a long-term investment with the goal of assisting them with education or perhaps travel, or a down payment on a home. Given the long-term strategy, long-term bonds are best suited here. Infrastructure bonds with long defined cash flows, inflation-linked bonds, government or zero coupon bonds (that don’t pay a coupon/ interest payment and the return is incorporated at maturity) may suit.

Inflation-linked bonds (see A bond that’s licensed to kill, inflation) are the only direct hedge against inflation, and as inflation grows so too does the capital value of the bonds. So assuming inflation continues to be positive, at maturity the issuer is then required to pay you the increased capital value of the bond. For example, in Table 1 below are two inflation-linked bonds. Their yield to maturity assumes inflation will be at the Reserve Bank mid-point of 2.5% until maturity of the bonds, providing an estimated yield to maturity for Envestra of 6.85% due in August 2025, and Sydney Airport of 7.25% due in November 2030. Both of these bonds are now trading at a discount to their face value, meaning the purchase price is less than the increased face value (due to inflation) of the bond. To buy the Envestra bond you would need to pay the capital value of $52,996, but the current face value (the amount Envestra would have to repay if say maturity was tomorrow) is $60,885. In effect you lock in a gain of $7,859.

The Sydney Airport 2030 bond matures in 18 years, a great investment for a baby now with the intention of being used for university fees.

Dalrymple Bay Coal Terminal is a floating-rate bond, which means its coupon moves with changing market expectations. It too is trading at a discount, but based on forward interest rate expectations the expected yield to maturity of this bond is 6.30%.

Table 1

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There are exchange-traded funds (ETFs) that specialise in inflation-linked bonds, such as the iShares UBS Government Inflation ETF. Minimum investment amounts are lower than direct investment, and this particular ETF is fully invested in government bonds, so very liquid, although returns will be lower than the direct access corporate bonds listed above.

Managed bond funds are another alternative, although there are risks involved particularly as investors withdraw funds, so this type of investment isn’t the set and forget type that I think you’d be seeking over a longer term for children.

Under 40s

If you are under 40 it’s likely that you are trying to build capital and your youth means you can afford to have an appetite for risk. Given you have a long investment horizon, higher-yielding bonds issued by smaller or lower credit quality issuers or securities sitting low in the capital structure, such as hybrids, may be appropriate. Hybrids have the advantage over shares of being less volatile, while in many cases providing greater certainty that the distributions (coupons or interest payments) will be made.

My preference would always be for over the counter (OTC) securities, as in essence you’re accessing wholesale markets, which I think offers better price for risk and return. See Table 2 below.

Table 2

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The recently issued Silver Chef fixed-rate bond senior debt security has outperformed in the short time since issue, primarily due to the change in the interest rate environment and the company’s strong equity performance over the same period. It is now trading at a premium, yet it still offers investors a high running yield and an attractive, known yield to maturity of 7.65%.

Moving down the list, while at the same time moving down the capital structure, National Wealth and Vero – both subsidiaries of well-known larger companies NAB and Suncorp Metway, respectively – show yields to maturity over 5% (both available to retail investors), while Swiss Re and AXA hybrids show a yield to maturity of over 8%.

While we’ve witnessed a continuing contraction in terms of yield to maturity, especially with the much sort-after fixed-rate bonds, there are still securities available offering higher returns.

Many investors in the under 40 age group won’t necessarily have the $50,000 face value needed to invest directly. If this is the case, there are a couple of higher-yielding listed securities that I think are worth considering and available in smaller parcel sizes. I’ve opted for three corporate hybrids: Healthscope Notes, and Caltex and Origin Energy hybrids (see Table 3).

Table 3

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Healthscope Notes offer a very high yield to maturity of 9.51%, however this does come with associated risk. Healthscope Notes are junior, subordinated capital in a highly levered capital structure. While the underlying credit quality is sound, with the business defensive in nature and with a highly predictable revenue and earnings stream, investors in this security are taking a view on the private equity owners’ ability of selling the company for a decent earnings multiple (either in a private trade sale or public IPO) before maturity. A sale of the business is the primary source of repayment for debt investors, with a refinancing of the entire capital structure a secondary option (and an option that didn’t work so well for debt investors in Channel Nine).

The other two hybrids I suggest here are from well-respected companies with sound credit metrics. However, the securities themselves are structurally difficult to understand and there is material risk around the securities being called at first opportunity. The recent rollover of the Goodman hybrid demonstrates the potential risks involved. Essentially Goodman rolled over the old hybrid into a new one where the new margin was below where Goodman would have been able to access new capital. Investors weren’t given the option to have the investment repaid, which is not a good outcome.

The newly listed major bank hybrids offer good yields but carry all the downside risk of converting to equity in the worst-case scenario without having any benefit of a higher share price or dividends if they outperform. So I haven’t recommended them. Equally they don’t tend to offer any diversification benefit, as most Australian investors own bank shares either directly or through superannuation or managed funds.

Summary

The fixed-income asset class offers investments across a very broad range of issuers and types of securities that can suit investors at any age. Inflation-linked bonds for children or investors at any age help preserve the capital invested and ensure that its purchasing power is maintained over longer time frames.

Note: All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.

Elizabeth Moran is director of education and fixed income research at FIIG Securities.