The bonds balancing act

The current investment focus has switched to shares, but bonds are still paying out good returns with lower risk.

Summary: Investors withdrawing money from term deposits and reinvesting in equities are taking on more risk. There are still a range of fixed interest securities with yields to maturity of over 6%.
Key take-out: Senior and subordinated debt bonds or hybrids offer greater certainty, less risk and less volatility than shares.
Key beneficiaries: General investors. Category: Growth.

Reports in the media of the "great bond rotation" are not being translated across to the domestic market.. While some investors have started to withdraw funds from cash and term deposits to invest in shares, many are reinvesting in bonds.

The great rotation makes sense if you’ve invested in US treasuries that are earning a paltry 0.86% for five years or 2% for 10 years, and then buy shares which show a yield of around 6% with the prospect of a growing share price. But in our domestic market there are still attractive corporate bonds paying over 6% yield to maturity without the risk and volatility of shares.

Term deposits

Not so long ago, cash seemed the “place to be”. Investors were nervous about global markets, and government guaranteed term deposits offered good relative value returns where your capital and income were guaranteed. While it’s still a safe place to park your funds, the returns on offer just aren’t that attractive, especially if you need that income to pay the bills.

The average term deposit interest rate across all maturities is now at a low 3.85%, very close to the low term deposit rates in early 2009. Figure 1 shows that the lower Reserve Bank cash rate has been the primary cause, but another part of the reason is that the major banks have been able to access wholesale funds at very low rates.

For example, this month ANZ raised $US1.25 billion for three years, priced at 57 basis points (bps) over US Treasury securities. The funds reportedly swapped back at 65bps over $A swap rates, providing ANZ with very cheap funds. The best term deposit rates are higher than the average across all maturities (see Table 1) but still low compared to bonds and shares.

Graph for The bonds balancing act

However, if you are withdrawing money from term deposits and reinvesting in equities you are taking on a lot more risk. See Figure 2 below, which shows a simplified bank capital structure. This shows the priority of payments should a bank go into liquidation. Term deposits are very low risk and sit near the top of the structure. As an investor, you’d expect to earn low returns because there is a very, very low risk that you’ll lose any money. As you move down the structure you take on more risk and would expect better returns. The lowest rung on the chart, “equities”, is where shareholders sit and they are in the highest risk, first loss position.

If you own equity (are a shareholder), you’d expect high returns as you’re taking on the highest risk.

Let’s try and qualify the risks you are taking:

  1. A term deposit or senior debt (bond) has a defined maturity where investors can expect to have their capital returned to them. Equity has no maturity date and thus no certainty you will recoup your capital. Eventual return is unknown and the investor must make a conscious decision to sell.
  2. A term deposit and senior bond have known interest payments and dates. However, equity investors can expect dividend payments on specific dates, but the board of the company must decide on a dividend rate and it can be cut or not paid at all, which may then lead to a decline in the share price. All four major banks cut their dividend payments during the GFC and the shares lost value.
  3. There is no price volatility with a term deposit and little volatility in a senior bond. Share prices can fluctuate significantly. Figure 3 below compares the value of three Commonwealth Bank investments: senior bonds are shown as the dark blue line (it assumes funds from maturity of one bond are reinvested in another senior bond), the Perls 3 are in green and the shares are in yellow. The graph shows the value of $100 invested at 31 December 2007, with coupon interest and dividends included in the returns. Dividend franking is not shown but would add roughly 1.4% to total returns if the investor can claim it. The point of the graph is to show the difference in risk and volatility or conversely certainty by investment.

    The senior debt investment earns a steady, known return. As you move down that capital structure, volatility and risk increases and forced sellers of either the Perls 3 or the shares at the low points could sustain severe losses. On the other hand, if you can pick the low points for the equity and sell at their highs you stand to make substantial profits. I’d suggest sellers at the top of the last bull run were few and far between. Investors drawn by the high returns probably kept buying into the market all the way to the top in an effort to make more money, and ignored the signs of an over-heated market.

Are we near the top of the equity market?

I really don’t know and I’d challenge anyone who thinks they do. The market could keep going and breach the 6,000 mark, but equally it could dip to under 4,000 points as well. The point I’m making is that there’s no certainty of income or return, and that you won’t know your return until you sell. Historic figures provide a guide but are not certain.

How to maximise return.

Maybe the question should be, how to minimise risk and maximise your return?

If you are looking for higher returns for your term deposit funds, there is a big asset class between term deposits and shares which offers higher returns with a high degree of certainty, without the much higher risk of shares (see Figure 2, and the orange circle in the capital structure).  Diversity remains the key to protecting wealth over the longer term. So, consider senior debt bonds, subordinated debt bonds or hybrids for greater certainty, less risk and less volatility. Table 2 shows a current list of bonds with yields to maturity of over 6%.

Suggestions for the current environment

It’s easy to get carried away with the market but here are a few general suggestions:

  1. Know your goals and keep to your considered portfolio allocation – find a balance.
  2. Invest a little of your portfolio to get those high returns and not a lot.
  3. Be protective. You are the only person that truly has your best interests at heart.
  4. Spend the time looking at the fundamentals of any investment. What fundamentals have driven the price higher, can it go higher still, and is it fair value?  Are you being properly rewarded for the risk involved?
  5. Keep diversification within your portfolio.

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

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