A look at corporate bonds

Jim Stening is the Founder and CEO of FIIG, the fixed income brokers. They’ve just put out a report commissioned from Deloitte about the corporate bond market in Australia and increasingly people are using bonds as a way of getting income and they certainly are looking at that if the Labor Party gets in and a lot of the dividend franking that’s currently used goes away, particularly for those who have got low tax rates and they are looking forward to receiving cash refunds. If Labor gets in there’ll be a lot of interest in corporate bonds I reckon, so it’s worth looking at it. 

But it’s interesting that Australian allocation to bonds is only about 10%, which is a quarter of the OECD average, so there’s not much interest in Australia in bonds and that’s obviously because of dividend franking and investors who are interested in income tend to look at equities because of the tax advantages. But I thought it’d be worth talking to Jim about how the bond market works so that you’ve got some idea of that and how FIIG works, which is quite interesting as well. 

Here’s Jim Stening, the Founder and CEO of FIIG.

Jim, obviously there’s a few very interesting things in the Deloitte report that you’ve commissioned.  The first thing that stands out I guess is the allocation to bonds in Australian pension funds is 10% versus the OECD average of 40%, and I guess that’s mainly due to dividend imputation in Australia.  People in Australia have always been obsessed with dividends because it’s tax benefits, whereas you have to pay full tax on bonds, but do you think that’s beginning to change? 

Well, I guess I don’t for a minute suggest that the taxation or the way that bonds are taxed is going to change in the very short term but it does highlight the taxation of these securities can create enormous anomalies and those anomalies do have implications in terms of portfolio risk.  But just on the face of it I think that is a very telling chart that you’ve highlighted, I mean we are literally bottom of the class when it comes to asset allocation in a global sense. 

What we’re looking at there is an assessment of best practice as determined by this OECD cohort and Australia is literally right at the bottom with Poland.  That says something about risk, it says something  about exposure, it says something about long term or life savings and how they’re being invested.

Just while we’re on that chart showing the various countries and their allocation to bonds, one thing that jumps out at me – and I don’t know if you know anything about this – but the top of the table is Czechoslovakia and the bottom as you point out is Poland, next to us at 10%, but Czechoslovakia is 90%.  Do you know why there’s such a difference between Czechoslovakia and Poland?  They’re right next to each other.

It’s a very good question.  I can’t give you an answer off the top of my head but it may well be that in Czechoslovakia there’s a requirement for pension funds to hold certain percentages of these assets.  Or there may well be the opposite, a tax advantage in that country.  I just can’t answer the question in a sensible way…

No, okay.  It’s interesting though.  It’s probably worth just talking about the difference in risk between equities and bonds, because I’m not sure everyone understands this.  The risk with equities obviously is volatility, but with bonds the risk is default.  Talk to us about the difference between those two types of risk. 

Well I think it’s very interesting.  I think a good way to explain this is, when you look at a bond, a bond is a security where the company issuing that security makes a promise and the promise is that they will pay you back on a given date and along the way they will pay coupons or interest payments on given dates.  If they don’t, that’s an event of default and if it’s an event of default that’s most likely to be the end of the company.  It’s something that if you are an issuer of making those promises that you need to take very seriously.  When you issue a share you’re obviously not making that promise. 

I think from an investors perspective, the decision you have to make is, what would you prefer?  Would you prefer a promise that you’re going to get your money back and a fair rate of interest, or are you prepared to take the risk that the company prospers and at some stage you’ll be able to exit an investment?  I guess to put it simply, the decision you’re making as a bond investor is, will this company remain solvent until the maturity date of the bond and then when you’re looking at an investment in equity, you’re looking for performance and outperformance and all the vagaries that are involved with that.

Another very interesting chart from the report is the fact that the bond market in Australia is larger than the equity market listed shares.  I think it’s $2.2b versus $1.7b and about half of that is corporate bonds and the other half is non-corporate bonds.  I don’t quite know what non-corporate bonds are.  Do you mean government bonds?

Yeah, that’s right.  The corporate bond market is over $1 trillion dollars.  Then when you add government debt and state government debt it gets you to that larger number.

It’s obviously a deep and liquid market, but most of it’s owned by institutions, aren’t they?

That’s right.  Obviously, something that’s quite often in the press is the amount of government debt and obviously over the last few decades there’s been quite a big swing in that.  At the moment that has been increasing over previous years, so it’s adding to that.  A lot of the fund managers, a lot of people do own bonds through fund managers, through their superannuation savings.  A lot of offshore investors own government bonds and corporate bonds in Australia.  The global market is very deep, there’s a lot of appetite for Australian credit and Australian bonds. 

Australia’s seen as being a very secure and well-governed country.  Debt investments are attractive.  Having said that, current levels of interest rates for Australian government debt are probably the least attractive they’ve been in a global sense for a very long time.

But there are a lot of Australian companies now issuing bonds, aren’t there?  I mean, one of the points about the report is the increased number of companies that are choosing to issue bonds rather than equities.  Tell us about how much of that you’re seeing.

Well I think, look, this is the fascinating thing about the Australian capital market.  Predominantly, a lot of companies – putting to one side the very large companies in Australia have been funded through traditional channels, so through say the bank, bank-funded.  And what we’re starting to see is that those companies have a choice.  To put it simply, a lot of companies in Australia, large companies, private and public, the listed entities, they either dilute ownership through the issuance of equity to raise capital and thereby no shareholders give up upside, or they go to a bank.  What we’ve seen over the last decade or so is that bank funding’s not necessarily an incredibly flexible thing and it’s prone to change and regulation can play a role there.  The growth of the corporate bond market is really important for these entities so that they have an alternative source of capital.  It might mean that through the corporate bond market they can access funding that’s longer-dated, that’s tailored, that doesn’t need to sit perfectly within a bank credit model. 

The growth in this market is an exciting thing for volatility we’ve seen in the past where the banks can sort of turn sour on particular sectors that means that participants in that space really have nowhere to go to access debt capital. 

From the point of view of investors, what’s the return?  I mean, as you say, the government bond rate is pretty low, it’s terrible in fact and term deposits are pretty low as well.  What sort of return have people been getting from corporate bonds?

The corporate bond market is, I suppose, divided into several asset classes within itself.  We do have an investment grade space that can offer yields of say, currently around 3-5%.  Then we have an unrated or high yield space that can offer yields around 5-9%.  There are in fact opportunities in the private debt market that offer well in excess of that as well.  I suppose the evolution that’s happening in Australia is what’s happened everywhere else in the world where this sort of – and it’s mentioned in the report – I think it’s really important that what the corporate bond market can do is fill out this gap in the risk spectrum that’s evolved in the Australian market where investors have a choice of cash or equities.  In every other sophisticated capital market investors have a choice of everything in between. 

With the evolution of the corporate bond market, you’ll start to see all of these different types of opportunities become available and people can access those assets according to their own targeted rates of returns or appetite for risk.  That’s really what it’s about, it’s about being able to provide that choice.  Prior to that choice being available, it’s all about when do I move from cash to equities, when do I move from equities to cash?  That’s not necessarily a very sensible way to invest, you’ve got to get the cycle right. 

I think it has relevance for property as well, I mean Australians are big property investors but when property isn’t performing or is unlikely to perform, where do you go?  Where do you put your money?  What’s the alternative?  The traditional alternative or the cultural alternative is cash.  As I said, where this market will evolve to is to provide all of that choice in between.

But what this Deloitte report shows us is that those who aren’t – so the key alternative to bonds is residential property.  As you point out, that’s what Australians invest in and there’s a graph in there that shows those who don’t invest in bonds basically have their money in property. 

Yes.

But the other thing that’s shown in the report is that residential investment property over the past 10 years, 2006 to 2016, has well and truly outperformed bonds and shares, 8% return per annum versus Australian bonds 6.1%. 

Yeah, look, that’s right and what it’s about is choice here.  I think not everybody has the same view on property and I’m no property guru, that’s for sure.  But as Australians we need to be put in a position where we can weigh the risk properly and if we’re weighing the risk between 1.5% or 2% cash rate and property investment when there are a whole range of other investments that are available, particularly when you overlay the risk that you’re taking or when you overlay an ageing population and a whole range of things.  Then if you want to sleep at night, if you don’t have to worry about being leveraged into property or other things, there are alternatives.

As we’ve said, the return that Deloitte is quoting for Australian bonds over the 10 years is 6.1%.  I take it that’s a total return.  How much of that is yield and how much of that is capital growth?

It’s a good question but generally speaking, I mean if you’re talking about bond returns over a 10 year period and in this instance, bonds generally mature over that time.  Predominantly that’s income. 

Do you have any numbers on the default rate in the corporate bond market?

In terms of the investment grade space, I’m going to say that it’s very low, if not zero over that term.

Okay, what about high yield?  I mean most people would be looking for the higher yield, 5-8%. 

Yeah, higher yield’s a different story and default rates in the US are probably a pretty good proxy.   Some of the very, very low rated high yield bonds have default rates over a 5 year period of around 20%.  And default is defined in a certain way.  Obviously there are considerations around underlying security and recovery and those sorts of things.  In Australia, FIIG’s been very active in that high yield space.  We’ve originated over 50 bonds and of the bonds that we’ve originated into this space over a long period here we haven’t had a default.

I’m just trying to get it clear in my mind what you’re saying then.  Is the US experiencing 20% defaults a good indicator or not?  It sounds like it’s not because you’re saying your default rate is zero?

Well, I guess I’d just make a fairly – that’s the lowest rating, which is a rating that companies are classified as by say Standard & Poor’s just above the event of default.  When you’re talking about companies or buying bonds in companies that are in that state, that’s what I would call it, an extremely distressed investment.  It’s not comparing like with like.  I guess what I was trying to do there, Alan, is just demonstrate that’s the outer parenthesis I suppose of risk in the corporate bond market. 

I suppose the other point to note is that over the period we’re talking about there’s been no recession.  We’ve had a GFC but we haven’t had a recession.  I mean, maybe their default rate can’t really be tested until you have a recession?

Well, I think those default rates that I mentioned – I can send you a table.  They’re over this sort of – as long as they’ve been operating those ratings agencies, but coming back – is your question about the investment grade default rate here in Australia?

Well, just investing in corporate bonds in Australia in general, I suppose I’m not distinguishing perhaps as I should between investment grade and high yield.  Investment grade, 3-5% yield, you would expect there to be a very low, if not zero, default rate…?

That’s right, and that has been the outcome even through the GFC and recession. 

For investors who are listening to this, my subscribers, they’re kind of looking at corporate bonds as an alternative to high yielding equities.  Therefore, they’re looking at the higher yield, the 5-6-7% yields, because they’re looking at after tax and that’s where they’re at.  What they want to know is what’s their chances of default if they bought bonds in that space?  If someone bought a 6-7% yielding corporate bond, given history, what is the chance of that thing defaulting?

It’s a good question, Alan.  I mean, some of it, it depends on the tenor.  If there was a three year bond it’s less of a likelihood than a 10 year bond.  If it’s a function of yield because of liquidity or size of issue, there needs to be a fairly deep sort of peer analysis of that before I can answer the question.  I’m not trying to avoid it, but at the end of the day, high yield means higher risk.  Investors need to be very cognisant of that and I think what’s important is, as I mentioned before, that what we’re talking about here is we’re talking about where you want to position yourself on this risk spectrum.  If you do choose high yield, I think it’s important to be diversified.  I think obviously investors look at small caps, they look at good yielding equities, everything is in the mix.

I suppose one of the interesting things about the bonds space is obviously the risk of if you’re holding to maturity, so it’s a 3 or 5 or even 10 year bond and you hold it to maturity, then the risk in that case is default.  But some people are buying and selling the bonds, aren’t they?  So there is some risk of price decline as well, particularly in an environment of rising interest rates as we’re now seeing.

This is the really interesting thing about, as I said, this sort of growth in the spectrum of opportunity.  It’s fascinating because, say for example high yield – I mean, high yield has a very different dynamic to say, a government bond.  Interest rates normally go up in an environment where the economy is prospering and companies are performing.  Quite often what that can mean is you get outperformance on these types of assets because the company has a better cash flow or improves the credit profile.  Whilst underlying rates may be going up, the performance of that particular credit might mean that prices of that bond go up.  That’s an important dynamic of investing in these types of assets.  It’s about diversification.

Are you saying that some corporate bonds go up in price, even when interest rates generally are going up?

That’s right.

And what causes that to happen?  How would you pick that?

Well I suppose it might be company specific, they might be really outperforming and have nothing to do with the economy itself.  More broadly speaking, what tends to happen is that when the economy is growing quickly, high yield bonds tend to outperform the underlying benchmark government bonds because government bonds are moving up in yield.  These are holding their own or even rallying or not moving higher to the same degree. 

In that situation, do high yield bonds tend to outperform equities or not?

Probably not, if a company’s doing really well and performing.  I think really the most leverage to be gained there is in the equity. 

If someone’s putting together a bond portfolio for income, as you say, the way to protect yourself is diversification.  How diversified do you think they should be?  Should they own 10 bonds or 20 bonds?

Well, I guess it’s up to the individual, but it’s diversified as you can be.  The more bonds you can diversify into the better as far as I’m concerned.  I think that’s a good approach.  People do invest in this space in different ways.  If you’re talking about high yield bonds, I mean predominantly high yield bonds particularly in this country there’s a real opportunity because issuers sort of tend to fall between the cracks.  They might not be able to get the funding they want from a bank but they don’t want to necessarily dilute ownership and issue equities.  They’re prepared to pay a higher price for this type of debt because they see the returns that they can generate through equity as much higher than that.  What tends to happen is as that company performs and fulfils on their forecasts and what have you, then what they’ll do is they’ll buy back that debt early and then be able to move to those traditional sources of debt say, in the bank market or offshore.

I suppose another way to diversify your portfolio is through term as well, so having some short term bonds and some longer term bonds.

Yeah, that’s right.  I think also there seems to be this paranoia in Australia in particular about quite often read about bond bubbles or interest rates moving up and I think it needs to be put into perspective.  I think in terms of bubbles across the other asset classes when you look at what could happen in property and what could happen in equities, it really does pale in comparison because the essence of a bond allocation is that it is less volatile.  It tends to smooth the volatility in a portfolio and that’s why when you look at OECD allocation or when you look at best practice allocation there is quite a large component that’s allocated to fixed income to provide that smoothness. 

Then, when you overlay what people are actually trying to achieve…  I think when you look at the European market, it’s all about security capital and maintenance capital, as opposed to generating enormous returns.  It makes a lot of sense to consider an allocation of at least 20%, double where we are now. 

Tell us a bit about how FIIG operates, Jim?  Last time I looked, you don’t charge brokerage, you just earn a spread between the buy and the sell price.  Explain that? 

Well, fixed income or bond markets are over the counter markets.  Probably one that your readers would be very familiar with is foreign exchange, you buy at a spread, that’s what happens in the fixed income market as well.  I think when we’re talking about new issues in the corporate bond market, that’s issued at a price.  There’s no fees, no brokerage, so that’s very similar to what happens in say, an equity IPO.  When we buy and sell bonds I think again it can vary across what type of bonds are bought and sold. 

Some are more liquid than others but generally speaking over say a five year bond, the spread would be around 20 basis points over the life of the bond.  That’s about a 1% margin.  I think when you compare that to say, a managed fund where over a five year period you’re probably paying between 50 and 70 basis points, which would total 2.5-3.5%, I think that’s a fairly good comparison.

Let’s get this straight, so the 20 basis points is not just on the transaction, that’s per annum, is it?

No, I’m translating that 1%.  Just say for example it’s a five year bond, in terms of that price.  It’s a 1% margin proxy.  It does vary.  I mean, it’s a bit like if you’re buying a container of bananas then that’s going to cost less per banana if you’re buying a bunch of bananas.  But at the end of the day, it is an over the counter market, we are crossing spreads and if we’re talking say a parcel with around, let’s just say $50,000, that’s about the margin.

1%?

Yeah.

That’s a margin between the buyer and the seller?  I’m just trying to really clarify this.  The person buying them is paying 1% more than the person selling them and you’re taking that 1%, is that right?

That’s right.

I see.  If you spread that – and the reason you talk about 20 basis points is you spread that over five years and it’s 20 basis points per year out of the yield?

That’s right.  If you’re at a 6.5%, then 6.5 to 6.3% - that’s the spread. 

I see.  You were relating that to a fund…?

A managed, as you know, they charge an NER or a margin or an amount to manage the funds.

Yes.

I think for example, 50 basis points a year.  If you wanted to hold that bond for five years through the managed fund, then by comparison that would be a 2.5% fee.

I see.  You seem to be saying, don’t hold bonds through managed funds, no point?

I’m not saying that at all actually.  I just think that one of the really interesting things, the way this market’s evolved in Australia is that rather than people having access to the raw materials that go into a fund, predominantly the way fixed income is accessed or offered is through that manufactured product which is a fund.  I think when we look across the other asset classes you’ve got direct equities, managed equities, you’ve got direct property, managed property…  It’s all about trying to provide the choice.  A good fixed income fund manager can deliver a lot of value.  It’s just a different way of accessing these assets.

That was Jim Stening, the Founder and CEO of FIIG.