Buying bonds: No time like the present

Bond returns are still good, but they are likely to compress soon.

Summary: Bond returns are very good relative value in this market, but they will compress in coming weeks as investors fully digest and accept the sorts of returns available in a low interest rate environment.
Key take-out: Bonds are offering very good reward for risk (relative value) and can be bought with high running yields to boost returns over term deposits, without taking on the much higher risk of shares.
Key beneficiaries: General investors. Category: Income.

Last week the Reserve Bank of Australia cut the official interest rate to 2.75%, the lowest level ever recorded, and it’s unlikely to stop there with the market predicting a further 0.25% cut this year.

The easing bias signals that the Australian economy is slowing and the RBA is trying to stimulate the economy. The signs for improvement aren’t great. A relatively large Australian government deficit (compared to previous years), poor data out of Europe, a slowing China and mixed signals from the US do not equate to a positive outlook.

I’ve been expressing the view for some time that interest rates will be lower for longer, and it seems other commentators are catching on. So, what does a low interest rate environment look like?

For a start, for investors, it means a much lower rate of return on investments. Chasing higher yield investments means you are taking more risk with your funds. Risk means chance of loss. That higher return is compensating you for risk of loss; can you afford an increased chance of loss of capital?

Term deposit rates and why inflation-linked bonds are a better option

Term deposit rates have generally moved down 0.10% to 0.20% (10bps to 20bps) since the rate cut and, funnily enough, the most attractive rates on new term deposits are due to roll over, just when the market expects interest rates will be at their lowest. The banks are able to access cheap overseas funding, if they need it, but credit growth is low and they don’t need to be quite as aggressive as they have in the past in offering good relative value returns.  A good 90-day to one year term deposit rate for retail investors is now around 4%. Higher rates are on offer, but generally that means you need much higher deposits of $500,000 to $1 million to invest, beyond many SMSFs. Many term deposit rates on offer for retail investors start with the figure three, and that is scary. If you factor in that the RBA target inflation rate is between 2% and 3%, term deposits offering “three something” returns are barely compensating investors for inflation.

The low term deposit returns (once you take into account inflation) are why investors should consider inflation-linked bonds (ILBs). They offer fixed returns of inflation (via a direct link to the Consumer Price Index) plus an attractive margin of around 3.2% to 4% (see table 1 below). The bonds hedge inflation risk, but also provide a very attractive return in a low interest rate environment. For example, if inflation jumped to 5%, then these bonds would pay 5% plus the margin of 3.2% to 4% to provide a return in the range of 8.2% and 9%.

Bond versus share returns

Bond investors typically compare the yield to maturity (YTM) percentage between bonds to get an idea of return. Yield to maturity includes the expected capital gain or loss at maturity, so it is a total return calculation. But if you want to compare returns with shares, a more accurate comparison is the running yield, which is based on income alone and is an indication of the income you can expect to earn in the next year. Running yield makes no reference to total return and is a far more equitable assessment if you are making the return comparison with shares, as ultimately you have no idea of total return with shares until you sell them.

On that basis, the table below shows some high running yield securities.

All nine securities (seven bonds and two hybrids) offer a running yield over 5.7%, with Silver Chef offering 7.95%. The majority of the investments are fixed rate, so you can lock in the returns for the next three to eight years. You will see that universally, yield to maturity is lower but it is a total return calculation and the “worst case” if you like (assuming the company continues to operate) and you hold the bond to maturity when you can expect a return of your capital. One effective strategy for investors in a declining interest rate environment is to buy high running yield bonds, hold for a while to receive the higher income but then sell 18 months to one year prior to maturity or if you think interest rates are going to rise.

The high yields on offer outstrip the dividend yields on shares (see Figure 1 below). While I haven’t added back franking credits (which would make share returns higher if you can claim them) shares are much higher risk and should earn much higher returns than bonds as compensation for forgoing the certainty of your capital being returned to you at maturity. The difference in dividend yield and running yield is marginal for a much greater risk of loss.

With low yields on offer for bank shares, investors would expect to be compensated by higher profits in coming years and thus higher dividends as well. Figure 2 compares the CBA dividend yield at year end versus its share price as at the same date and again as at today. The current CBA share price indicates returns should improve in the next 18 months or so. However, recent UBS research indicated that for first-half 2013, bank earnings per share grew by 6.2%, but more than half (3.6%) was due to lower bad and doubtful debts and 1.9% due to cost cutting and not growth per se.


Summary

Bond returns are very good relative value in this market, but I expect they will compress in coming weeks as investors fully digest and accept the sorts of returns available in a low interest rate environment. So, if you’ve been thinking of adding bonds to your portfolio, there really is no time like the present.

I think the risk for shareholders is very much on the downside, with current high share prices forecasting growth in the next 12 to 18 months when the fundamentals don’t match market expectations.

Bonds are offering very good reward for risk (relative value) and can be bought with high running yields to boost returns over term deposits, without taking on the much higher risk of shares.

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.

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