Low-risk bonds a nice fit

Government bonds have done nicely over the last two years, returning almost 10%. Now, inflation-linked bonds look quite appealing.

PORTFOLIO POINT: Demand for Australian government bonds is unlikely to wane, but inflation-linked bonds are offering added protection in uncertain times.

When I started contributing to Eureka in September 2010, I constructed a model portfolio as an example for investors. The $1 million portfolio was based on a person nearing retirement who wanted to increase certainty with a known income stream.

The portfolio was meant to complement an existing share portfolio, so I also had a preference for issuers that weren’t listed on the ASX. The ultimate goal was to return 4% to 5% over inflation (assuming inflation stayed within the 2 % to 3% band), with the aim of a nominal return of between 6 to 8%.

At that time I had a personal view that interest rates were near the top of the cycle and I expected them to decline (even though the market had expectations that interest rates would go higher). I’m hoping most of you will instantly think lower interest rates means higher bond prices, and thus my preference for fixed-rate securities which has proven to be profitable had you replicated the portfolio at that time.

With income and certainty in mind, I opted for predominantly low-risk bonds, which have proven to be less volatile compared to shares over the same period (see tables 1 and 2 below). The annualised holding period return was 9.81%, exceeding my goal of 6 to 8% nominal. The return had two components:

  1. Coupon payments
  2. Capital gain or loss if sold on the 18 July

Coupon payments over the period were $125,628 and capital gain in value of the bonds was $56,303. On coupon payments alone the return equated to 6.80%, still within my target range.

Table 1

Source: FIIG Securities

Table 2

Source: FIIG Securities

The stand-out performer over the period has been the Queensland Treasury Corporation inflation-linked bond (ILB). This bond is known as a semi-government bond; that is one issued by a state or territory. The ILB was bought for $52,436 and as at July 18 was worth $63,222. This meant over the period the bond price appreciated by 20.6%. Now I would typically include an allocation to government bonds in my portfolio because they are the lowest-risk assets, are highly liquid, and no other assets can replicate the benefits of government bonds. This last 18 months demonstrates why holding government bonds has been hugely beneficial despite the low up-front promised returns.

Would I recommend government bonds now?

That all depends on your view of global markets. Part of the reason for the outperformance of government and semi-government bonds was that foreign investors consider them a safe haven (they hold about 80% of all Commonwealth government bonds outstanding), which are still paying a relatively high coupon rate.

Interestingly, the Czech government has recently buying Australian government bonds. This highlights the imbalance in global return expectations. Australians view the 2% interest rate as too low, while others looking to preserve capital by investing in the lowest-risk assets available view it as great relative value.

I don’t expect demand for Australian Commonwealth or semi-government bonds to change any time soon. There’s far too much uncertainty in the world, and while Australia maintains its AAA credit rating and relatively low debt to GDP, I expect foreign investors to continue to buy our government bonds. But, the risk is that that view changes or perceived global risk declines, or there’s a spike in inflation and investors start to sell their government bond holdings. In that instance the return or yield would rise and bond prices would decline. So, while I’ve made a good return on my semi-government bonds, I’m going to sell them and crystallise the gain. I’m then going to reinvest the proceeds and a little more from my at-call account to buy an Envestra ILB (see the details in Table 3).

Table 3

Source: FIIG Securities

So, let me talk through the table above. I purchase the Envestra ILB, which currently has a face value of $121,430, at a discount for $104,545. This ILB, like most ILBs, is very long dated (maturity is due 20 August 2025) and each quarter the face value of the ILB changes to account for inflation (indexed to CPI). So, the Envestra ILB’s face value has increased from $100 to $121.43 since first issue.

Now, I’m buying the bond at a discount of $16,885 ($121,430 less $104,545). If the ILB were due for repayment tomorrow, Envestra would pay out the accumulated face value and I would realise a gain close to the difference I’ve calculated today.

The coupon of 3.04% is the payment made on a quarterly basis to investors, although as I’m buying this ILB at a discount, it’s higher at 3.53% and this is known as the running yield. The coupon is calculated on the current face value ($121,430) and it is the growth in the face value and the growth in the coupon payment over time which provides protection against inflation. Note, the yield to maturity calculated here assumes an average inflation rate over the next 13 years of 2.5% (the mid-point of the RBA’s target).

Back to the portfolio

The AXA SA Tier 1 hybrid is the highest-risk security in my portfolio (although it is still investment grade) and being higher risk, its price has not performed as well as the QTC ILB. But AXA’s  yield of around 13% makes up for the lack of price movement. Fortunately most other bonds in my portfolio have appreciated in capital value. The CBA retail bond is the exception here, declining in capital value. However that’s a floating-rate note (tied to BBSW benchmark 1.05%), which I’m holding for when the market perception of future interest rates moves higher, and this will be reflected in higher coupon payments through higher BBSW .

Bond prices do change; investors can make gains or losses but have the safety net of holding to maturity (with the exception of perpetual securities) if they don’t want to sell at a loss. This also means investors can afford to relax in that as long as the company remains solvent, coupons (interest payments) and the principal will be returned to them at known future dates.

For more information please read previous articles “Your $1m bond portfolio”, “One year on, a happy return” and “A bond that’s licensed to kill, inflation”.

Note: Elizabeth does not own any of these securities and would recommend a different portfolio for those thinking investing at this point in the interest rate cycle.

Graph for Low-risk bonds a nice fit

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

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