Direct bonds join defensive armoury

The corporate bond market is finally open to retail investors. Where once they had to give the job to a bond manager or rely on the ASX-listed menu of illusory hybrids and convertible notes, self-managed super funds can now hold debt issued by some of Australia’s biggest companies.

The first series of exchange-traded bonds (XTBs) offered by the Australian Corporate Bond Company consists of 17 senior bonds from companies including BHP Billiton, Telstra, Lend Lease, Stockland, Dexus, Wesfarmers and Woolworths.

All the XTBs pay fixed rate coupons, and there’s a juicy range of income on offer. A Stockland bond which matures in November 2020 pays 8.25%, for instance, whereas a BHP note with an October 2017 maturity is paying 3.75%.

Those are attractive yields when the cash rate is 2%, but these super-secure instruments come with a catch. As interest rates drop, the fixed income from a bond becomes relatively more attractive compared with other alternatives. This attracts buyers, who bid up the price.

That’s exactly the case for the 17 bonds offered as XTBs, which in late May were all priced at a premium to the $100 par value, the issue price.

On May 22 a Telstra bond paying 7.75% and maturing July 2020 was being offered for $126.92. But when a bond is paid out at maturity, the holder will only get the $100 par value and the final coupon.

If rates in Australia drop further, the price of that Telstra bond will likely increase, but in five years’ time the best the bond can be worth is $100.

What’s a bond worth?

The value of any fixed-rate bond includes its ever-changing market price and its never-changing coupon. If interest rates go up, the price will go down. If rates go down, the price will go up.

These changes in price are more volatile the longer it is before the bond matures, as the relative value of a greater number of coupon payments is discounted back to present value.

The 17 XTBs vary in maturity between two and five years, and the bonds which mature five years out will be more sensitive to rate movements than those closer to maturity.

The XTBs are structured to include a 0.40 percentage point annual fee, paid to ACBC, which comes out of investors’ returns. In return for the fee, ACBC conducts all the admin and contracts a market maker to step in when prices veer too far from the wholesale market prices, to keep the XTB price close to the underlying bond prices.

What’s the return?

The most important number is the yield to maturity, which is the annual return provided by all the coupons as well as any gain or loss on maturity.

Based on market prices at launch on May 12, ACBC reckons the XTBs will pay yields to maturity of between 2.595% and 3.911%, after fees.

ACBC’s pitch to investors is that that’s a better return than term deposits.

And they’re right, but anything can happen. If rates continue to fall, they’ll do well. If they rise, then they won’t look so good. And of course in the (albeit unlikely) event that any of the bond issuers goes broke, then the XTBs could end up looking very bad indeed.

Matching for liabilities

So long as they accept that they are very unlikely to get a better deal from owning corporate debt than professional investors, self-managed super funds might still see benefit in ACBCs listed bonds.

For a start, the yields to maturity are well above the rates paid by term deposits. For now.

But a DIY fund may have other priorities, and investments with a stated maturity and price guarantee could suit members who know they have a liability due on a certain date. Just remember that you’ll be starting off 0.4% behind the professional investors due to the charges.

What next

Floating rate bonds offered by the major Australian corporations would be a great addition to the retail bond market. ACBC says it is working on it. For now, the market for corporate debt is open. Self-managed fund trustees might not choose to rush in immediately, but it’s good to know they can.