Income securities: An insider's guide

PORTFOLIO POINT: Bonds are offering dismal returns for investors, but is cash the answer?

One of the toughest factors facing investors just now is that while the sharemarket is extremely difficult, the fixed-income market does not immediately offer a simple remedy.

As you can read elsewhere in today’s edition, the most common income-focused notes in the Australian market are hybrids, but in many cases they have been loss-making in terms of total return over the last six months.

Yet one of Australia’s best-known bond brokers, Jim Stening of FIIG, today explains how the situation is similarly unsatisfying in the government bond market where the coupons (interest rate offered) are so low as to be utterly uncompetitive with cash.

As Jim explains, in calmer markets hybrids will have their place...it’s just that right now, the equity element in these notes is dragging them down. Jim also believes that important development work, which will soon allow government bonds to become easily accessible to retail investors, will also be rewarding.

But what investors want to know in mid-2012 is, what’s better than cash? The answer lies in well-selected corporate bonds and some highly-regarded notes. For example, the Woolworths hybrid has survived all the shocks of recent weeks intact'¦but let’s hear what Jim Stening has to say.

James Kirby: Jim Stening, is the bond market a bit unreal at the moment. That is, yields are historically low and prices are historically high, and there are suggestions that there is something of a 'bond bubble’. How do you think retail investors should deal with this information?

Jim Stening: From a certain aspect I have sympathy with that point of view. I think that obviously we’ve got very low nominal yields, record low levels, out to 10 years. So when you’re looking at the bond market, and particularly those high-quality bonds in isolation, certainly there has been a lot of buying of those assets. For that to be reversed would cause significant loss in value. I think what needs to be addressed here is that there are other areas of the bond market where people can invest. Floating rate assets obviously can protect you from that duration bubble that people refer to.

People are taking their risk bets off, and so a corresponding move at the same time is the widening in credit spreads. So that’s an opportunity for people as well, because what tends to happen is, if those nominal yields, or if those fixed rates yields move up, then the reasons for that would be that people are more confident about the outlook for the economy.

JK: Can you just explain to the average reader what that means? Widening of credit spreads.

JS: Well, what it means is that if people are more nervous about the economy or about markets, then for them to be comfortable lending money to corporates and other entities they require a higher premium. So they need to be satisfied for the risk they’re taking. What happens is, the cost of borrowing for a broad range of corporates, including the Australian banks, pushes out, so it makes it more expensive and therefore a better return for investors.

JK: We see a lot of issuance now at the moment from banks and corporates. Is there an exceptional level of issuance activity or is this normal?

JS: I suppose at this time of year, generally, you do see a fair bit, in particular those sort of regulatory capital issues coming in at the end of the financial year. I think probably, the period around March of this year, there was an extraordinary amount of issuance. I think it was over $5 billion of that sort of Tier 1 capital from those types of issuers. I suppose, if you look at this half in the context of previous halves, yes, there’s certainly a bit of a flood of those types of assets available.

JK: And is the majority of that issuance aimed at retail investors?

JS: Well, these assets have always been issued into the market. There are increasing numbers of issues coming, or there have been in the last six months, but yes, they’re definitely aimed at the retail space. I think retail investors need to be careful to read the detail of these individual issues. Quite often there are some opportunities available for the same type of risk at much better returns.

JK: Is it the case though that the minimum set by the issuer might be $5,000, for example, but not everybody actually applies that minimum? For example, the NAB subordinated notes were supposed to have a $5,000 minimum but some brokers were putting a $50,000 minimum on it.

JS: That might be something that those brokers are doing internally. Obviously, if it says in the PDS that they’re available down to that amount, people can apply for them and pay for them.

JK: Depending on which broker you use is it?

JS: Yes.

JK: There have been stories that there is a potential for government bonds to be available for retail investors, and that there is action in Canberra to make it genuinely possible.

JS: I think that that’s something that’s definitely going to happen. There’s a definite commitment from the government to make it happen, and from other stakeholders.

JK: Yes, but has something actually occurred that makes you think it will come to pass?

JS: Nothing that I can put my finger on, but I do know that '¦ certainly this time last year I would have expected that access to listed government bonds would have already been in place. I think it’s really only been deferred rather than dismissed.

JK: Yes. Are you disappointed it has been deferred?

JS: From our business’ perspective, I’m not certain that it’s that relevant. I think in terms of retail demand for these things, the challenge listed government bonds will have is competing with government guaranteed term deposits. You’ve got those yield levels on three-year bonds at record lows – all the bonds at record lows close to 3% in the 10-years – whereas investors can get a government guarantee up to $250,000 in a term deposit where there’s a lot of competition.

JK: And it might be double that rate?

JS: It will certainly be in excess of that rate I would argue. So I think that that’s a real challenge because the market that they are targeting obviously has alternatives. Then, when you overlay that we’re at these record low levels, if rates do in fact move up if we move out of this global malaise, then first-time entrants into that listed fixed-rate market could well experience a devaluation or unrealised losses.

JK: Because they will be caught with the lower rate issuance, is that it?

JS: That’s right. They’ve invested at a lower rate. So, timing-wise, I’m not certain it’s ideal, and that might mean that it’s delayed further.

JK: And so what people are doing is they’re going into the corporate notes hybrid area where the rate is actually competitive.

JS: Well, that’s right, and the challenge there for people '¦ is that they’re hybrids because they are part equity and part debt for various reasons and, as such, they behave like equities in market downturns. The volatility is not as extreme as an equity investment, but they’re more susceptible to fluctuations in the underlying equity.

JK: What is there in the retail market that doesn’t display these equity-like volatilities that are not government bonds?

JS: This is the challenge. It depends on which sector of the retail market we’re referring to, but top-end retail investors do have access to corporate bonds of around $50,000. If you’re talking about someone who is looking to apply for $5,000 of these listed hybrids, there’s no access to those type of assets.

JK: So what is there for retail investors in the sub $50,000 minimum market that isn’t a hybrid?

JS: Well there’s listed senior paper. CBA did a deal about 18 months ago and that’s a floating-rate note. There are those types of listed assets that are senior bonds, but if you’re talking about a pure retail proposition, there’s not a lot more.

JK: Where does the bulk of the money go these days from the retail end of the market?

JS: I think the bulk of it is actually sitting in cash. The competition for deposits means that those types of yields are really competitive, particularly for retail investors.

JK: Can you prove that Jim, that the bulk is in cash?

JS: I suppose, looking at say, self-managed super funds, and I understand that’s probably not retail, or pure retail, but there’s a heavy weighting into cash. As far as fixed income goes, I think the fixed income allocation is around 1%, so that speaks volumes.

JK: So 1% is remarkably low isn’t it, on any measure?

JS: It is, absolutely.

JK: In the natural course of things, what would it be in a classic asset allocation provision?

JS: Well, I think, arguably 20-25%.

JK: But part of this is because of the lack of choice, right?

JS: Absolutely, lack of supply and it is a challenge. But I think the moons are lining up for the development of this market. The banks are less likely to be growing their balance sheets and more likely to be bringing people to the debt market to raise capital.

I think, also, a huge range of Australian corporates in Australia have always been bank-funded, rather than looking at capital markets for opportunities. And that’s where we see a great opportunity.

JK: One of the things I wanted to talk to you about is bank notes don’t have certain security – that they are subordinated and are lower ranking. But, correct me if I’m wrong, I think the majority of Australian investors ignore all that, and say “It’s most unlikely that one of our four banks is going to go broke”, and they take the risk. Are they right to do so?

JS: Well, they’re not right to do so, but they do. And whilst the outcome of that way of making an investment decision might be fine '¦ I don’t think there’s a huge likelihood that banks will fail. What people need to consider is that they may be able to get a better return for similar risk, even from the same issuer from an alternate source.

JK: We’ve seen all the banks coming out with hybrid notes, which has given them an alternative to European funding. And we’ve seen some big corporates come to town, I’m thinking of the Tatts issue just the other day. Where do you think it goes from here?

JS: I think that there’s a trend that will emerge –we’re going to start to see more issuance. I think that there’s recognition out there that the savings pool is a huge opportunity to provide capital to Australian corporates. Whether that’s intermediated by the banks, or whether that happens directly, it’s going to happen. So I think that means we will see far greater issuance. Whether it’s listed or not, I’m not sure.

JK: For the retail investor, is there an argument to be made that the unlisted could be better, in that it will be a less volatile?

JS: I think there’s some sense in that. I actually also think that unlisted is far more liquid. That might sound like a perverse comment, but it’s really interesting that a company like FIIG turns over a lot more in bonds over-the-counter than the whole of the Australian Stock Exchange in fixed income-related assets.

JK: Thank you for talking to Eureka Report.