Fixed income finds new fans

Now within reach of retail investors, the advantages of bonds make investing sense, writes Rod Myer.

Now within reach of retail investors, the advantages of bonds make investing sense, writes Rod Myer.

The wild volatility in sharemarkets since 2007 has got Australian investors looking for safer investments. Term deposits have been popular, especially when rates have been high, but there is also an increasing awareness about the investment potential of investing in bonds, or the fixed-interest market, as it is known.

Bonds used to be the preserve of the wealthy and institutional investors, with minimum exposures often being in the hundreds of thousands of dollars. But recent developments mean investors can buy government and corporate bonds on the Australian Securities Exchange for as little as $100 a unit, putting them well within reach of retail investors.

Australian retail investors are underweight in fixed interest as an asset class. Anne Anderson, the head of Asia-Pacific fixed income at UBS Global Asset Management, says "we are at the very lower end of OECD countries in terms of fixed-interest weightings. Historically, we've had a culture of investing in bank deposits and equities, which has been encouraged by the tax system, especially through franking credits [which make share investment tax effective]." Australian fixed-income weighting is probably less than 10 per cent of the average retail investor's portfolio.

Anderson says: "One size doesn't fit all, and as people move towards the later end of their working life, an increased fixed-income exposure will help preserve capital." Typically, fixed interest should make up between 20 per cent and 40 per cent of a retail investor's portfolio, she says.

So what are the advantages of fixed-interest investment? David Simon, a partner with Westpac Financial Planning, says the beauty of investing in fixed income is a "non-correlated investment" to the sharemarket, meaning the bond market acts independently of the sharemarket.

"After the global financial crisis, the sharemarket had three years of torture while the bond market had near double-digit returns," Simon says. In the year to June 2012, federal government bonds returned 14.2 per cent while shares fluctuated wildly.

So if bonds can be a profitable investment, why do so many people not understand how the market works? Put simply, a bond is a loan made by an investor to a government or corporation. The borrower issues a bond in recognition of the loan and promises to pay interest at a certain rate and to repay the capital after a set period, which can be from one year to 30 years or more.

Here is the complicated bit. Bondholders can sell bonds if they don't want to wait for maturity, which means bonds can be traded much like shares. Bond prices move in an inverse relationship to interest rates. Say, for example, you buy a $100 bond with a coupon (interest rate) of 5 per cent. If interest rates move up to 10 per cent and you want to sell your bond, you will get a shock.

That's because investors can now buy a bond yielding 10 per cent for $100 from the issuer and they won't want to pay you $100 for a bond paying 5 per cent. So what happens is the capital value of your bond will fall to $50 to ensure a buyer gets the same 10 per cent yield the new bonds are offering. Other factors that affect bond prices include the length of time to maturity, economic conditions and views on the financial stability of the issuer. But they are complex, although the previous description is fundamentally correct. This volatility is also the sexy bit, because people can trade bonds according to what their view on interest rates might be. Trading can involve buying and selling, or simply buying your discounted bond at $50 and holding it to maturity, when the issuer will repay its face value of $100 - delivering a capital gain and a healthy interest rate along the way. The big gains for bonds since the global financial crisis came as falling interest rates forced capital values to rise.

Anderson says fixed interest is a "heterogeneous" asset class - lots of different bonds are on offer and they have varying characteristics and risks. Know what you are looking for before you go into the market.

Commonwealth bonds are the benchmark security because they are considered low risk. As a result, they pay low interest rates. The ASX offers a number of fixed-rate government bonds (an advisory table is on the ASX website) with maturity dates of between December this year and April 2029. They have coupon-interest rates of between 6.25 per cent and 2.75 per cent depending on interest rates when they were issued. The table also demonstrates the workings of the market. It shows one bond with a 6.25 per cent coupon has been bid up in price to $107.87 in an environment of falling rates. That cuts its effective yield to about 2.49 per cent when the higher price, and the fact that if bought now you will face a capital loss at maturity in 2015 (when you will receive only $100), are taken into account. There are also a smaller number of Commonwealth index-linked bonds listed on the ASX, where the capital value of the bond increases with inflation, which protects the real value of the investment. Interest is paid on the growing capital value and the whole indexed value is repaid on maturity. In return for those benefits, the interest rate is lower than for conventional bonds.

Laurie Conheady, fixed-income strategist at JBWere, says indexed bonds would usually be attractive to retail investors, especially those with self-managed super funds.

"But our position on the interest-rate cycle means taking long positions in government bonds is not a good idea now," he says. "We have been underweight in fixed interest since early 2013 because we see it as being overvalued and coming back in price." To the uninitiated, that means investors chased bond prices up (and yields down) as part of the yield contagion that also hit sharemarkets. The resulting record low bond yields mean bond prices will fall when interest rates inevitably move up. That process has begun. Since US Federal Reserve chief Ben Bernanke flagged the possible end of quantitative easing, or money printing, US bond rates rose about 1 percentage point to 2.5 per cent. Australian bond rates jumped about 80 basis points, but have since fallen back a little. With interest rates in the medium term likely to climb further, Conheady says investors would do better by avoiding fixed-rate bonds and choose floating-rate securities instead.

This introduces a new income-security option. Companies issue floating-rate securities with yield expressed as a margin over the 90-day bank-bill swap rate. That means an investor is paid the current bank-bill rate plus the margin, which is generally between 1 per cent and about 4 per cent. Consequently, if interest rates go up, so does the investor's return, which eliminates capital losses.

Attractive as the ASX-listed floating-rate securities are, they are more risky than government debt, and many are known as "hybrid securities". That means that while paying interest, they have some of the traits of equities, but characteristics vary with different hybrids. They include the ability to be converted into equity by the issuer, cessation of distribution payments in certain conditions and the ability to change maturity dates. Many hybrids also rank just above equity in the event of a wind-up, making them less likely to be repaid in the event of trouble. These risks do not mean hybrids aren't a good investment option, Simon says. But do you homework, because "in some cases hybrids are not far off the risk of an equity investment but don't have the potential of equity returns," he says.

Martin Ryan, a principal of bond investor Mutual Limited, says banks are increasingly issuing hybrid instruments to comply with regulators' demands that they improve their capital ratios following the GFC. "Regulators require that these hybrids are constructed to act more like equity in the event of financial difficulty," he says. "The good news for investors is that the banks therefore pay a higher margin above the swap rate."

Another option for retail investors are bond funds that offer professional managers and a spread of investments. UBS, for example, offers an Australian bond fund, a diversified fund that invests in a range of bond types and markets. It also has a diversified credit fund focused on floating-rate securities. Many other groups such as Macquarie, Vanguard and Pimco, led by US bond guru Bill Gross, offer bond funds.

The annual costs of such investments are generally between 0.24 per cent and 1 per cent of your total investment. Simon says funds have the advantage of professional management with the skills to "trade behind the scenes and take advantage of price mismatches, arbitrage, the timing of distributions and maturations, and have access to initial product offerings." Yet another option is offered by Australian group FIIG. It buys exposure to the professional bond markets, where minimum purchases might be $500,000, and breaks them up in portions for retail investors. FIIG's education director Liz Moran says the company offers investments of $50,000 and "we say you should have exposure to five bonds, which is $250,000." That might still be a bit much for many investors, but Moran says FIIG is working on a $10,000 minimum offer.

How do bonds work ...

Governments and their authorities, banks and corporations issue bonds in return for borrowing money from investors. In essence, the bond is a promise to repay the investor on a certain date and a commitment to make interest payments at a specified level at regular intervals.

Coupon The interest rate to be paid on the face value of a bond when it's first issued.

Maturity When the capital value of the bond is returned to the investor.

Perpetual Bonds that never mature.

Secondary market Bonds are often not held until maturity but sold in the secondary market where they are priced in an inverse relationship with interest rates.

Take a $100 bond issued with a 5 per cent interest payment. If interest rates double to 10 per cent, the value of the bond falls to $50 as investors will demand the 10 per cent return they could get on a new bond. If interest rates fall to 2.5 per cent, the bond value will double to $200 to represent the 2.5 per cent yield.

Things such as the term to maturity and economic considerations also influence bond prices but this is basically how the market works.

Yield The effective return to an investor based on the price of a bond in the secondary market and its interest payment level.

Comparing bond and stock returns

Those who doubt the value of bond investment should look at the chart comparing returns from the S&P/ASX 200 accumulation index with the UBS Composite Bond accumulation index going back to September 1989.

The UBS index approximates bonds available in the Australian market and assumes all interest is reinvested. It shows that bonds have climbed steadily while the sharemarket gyrated. In fact, during the period bonds have returned an average of 8.85 per cent yearly compared with 8.74 per cent for shares.

Hybrid securities promise value

Investment group Clime Asset Management has identified a possible investment opportunity in buying floating-rate hybrid securities issued by Macquarie and Suncorp. Both have fallen well below their $100 issue value because they offer lower margins over the bank-bill rate than more recent issues, which pushed down their relative attractiveness. Macquarie (ASX code MBLHB) offers a 1.7 percentage point margin on the bank-bill rate, is trading around $73 and pays annual interest of around $4.50 at current interest-rate levels in four quarterly payments. That equates to a 6.1 per cent return for investors buying at current levels.

Suncorp securities (SBKHB) are trading around $64.40, pay a margin of 75 basis points over bank bills equating to $3.50 a year, or a return of about 5.4 per cent. Clime emphasises that both issues are perpetual, but their issuers may move to redeem them at $100 at some point in response to changing regulations around bank capital. If that does not happen, the two represent attractive long-term income returns, Clime believes.

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