As published in FS Advice on 6 February 2017
The biggest global investors all own bonds. Primarily they are a defensive asset that diversifies away from higher risk asset classes and provides reliable income and capital stability. While the importance of bonds has always been well understood by professional and wholesale investors, providing individual investors with a simple channel to access these benefits has been a major hurdle
At its simplest, the domestic bond market can be broadly broken into two main sectors: government bonds issued by the Commonwealth and State Governments; and corporate bonds issued by companies. As at 30 June 2016 the value of all domestic federal and state debt on issue exceeded $500 billion, whilst corporate debt on issue exceeded $300 billion. The corporate bond market comprises bonds issued by local companies or international companies in Australia, with most traded in the ‘over the counter’ (OTC) market, or more simply - a market without an exchange .
This paper will deal specifically with the corporate bond market.
In recent years, Australian corporate bond issuers have raised capital in offshore markets. (see Figure 1). Approximately 80 per cent of the outstanding value of bonds issued by Australian-based corporations, are issued offshore. A decade ago, this figure was considerably lower at around 50 per cent.
The offshore market is favoured by companies that want a natural hedge against their foreign currency revenue. It has also proven easier to issue large amounts and for longer terms in the offshore market than it has in the domestic market. Australian banks, as the largest borrowers, are heavily reliant on international markets for debt funding.
Figure 1
Why bonds?
Fixed income assets, in particular bonds, are popularly referred to as ‘defensive’ assets because of their capacity to:
- Reduce the volatility of overall portfolio returns;
- Provide a natural hedge to the economic cycle; and
- Help to match future expenses (liabilities) with bond maturities
It is important to note that bonds serve a different function to conservative investments such as savings and deposit accounts. Just like equities, the market value of corporate bonds can go up and down depending on external or internal factors like profitability, interest rates or economic conditions. Bonds can be sold prior to maturity providing investors with liquidity, unlike deposits.
The real benefit of bonds comes from the certainty of outcome they provide investors. Fixed rate bonds provide a definitive cash flow over the period of the bond and a known return of capital at the end of the term.
Over the last few years, high quality fixed rate bonds have provided comparable, and in some cases, better than average returns, compared to Australian and international shares and listed property. They have also been less volatile than shares, with fewer years of negative performance.
The other important aspect to remember with bonds is that within the same company, they are lower risk than shares.
This is due to a legal obligation to repay bondholders before shareholders in the event of a wind-up. The repayment requirement is shown in a company’s capital structure (see Figure 2) . This is crucial in determining whether the return adequately compensates the investor for the risk involved.
Equities (or shares) are the highest risk asset and the very last rung of the capital structure, one step up are hybrids, and thus should provide the greatest returns. In contrast, most corporate bonds sit higher in the structure and are safer in the event of liquidation than equities and hybrids. Generally corporate bonds are lower risk and offer lower returns. Including bonds in investment portfolios lowers volatility.
Simplified bank capital structure showing priority of payments in liquidation
Figure 2
Source: FIIG Securities
How to invest in bonds: Indirect vs direct
The vast majority of bonds available to Australian investors are bought and sold in the over-the-counter (OTC) market. While equities trade on the Australian Stock Exchange (ASX), very few bonds trade on the ASX. This means that in order to buy and sell bonds, investors use a broker who matches buyers and sellers in the market. Like stockbrokers, finance brokers and insurance brokers, fixed income brokers in Australia are licensed and regulated by the Australian Securities and Investments Commission (ASIC).
1. Indirect Ownership (Funds and ETFs)
There are a wide variety of investment funds that invest predominantly in government and corporate bonds. Like equity funds, these funds are built around a unit trust structure where the investor purchases units in the trust and the trust undertakes the investment. These funds can be actively managed or indexed to a benchmark and also have varying investment mandates and risk profiles. The funds generally sit within the defensive component of an overall investment portfolio. The key features of these funds are their capacity to provide sustainable income, low volatility and even the potential for capital growth over the long term.
One of the major benefits of investing in a bond fund is the access to professional mangers with a deep understanding of the bond market and the ability to maximise risk adjusted returns. As with most unit trusts the major risks are associated with liquidity, the pooling of assets and the fees that apply.
Investors also have the option to invest indirectly in bonds through exchange traded bond units (XTBs). These were created as a way for retail investors to buy into the wholesale bond market. Investors buy units in a trust that invests in a single bond. The primary benefit of the XTB units is their very low minimum investment. Theoretically, investors can get access to bonds in one of the XTBs for as little as $100.
2. Direct Ownership (investor portfolio)
While many investors seek to invest in bonds through managed funds others prefer the control provided through direct ownership. There are a number of advantages to investing directly in bonds over managed funds:
- Offer direct investment in specific bonds rather than units in a managed fund
- Ability to select individual bonds to suit specific requirements including:
- The company that issues the bonds
- The quality of the bonds (e.g. investment grade versus high yield)
- The level of return (yield)
- The frequency of cash flows and coupon income paid
- The maturity dates and the use of capital to match expenses
- No pooling of money or assets
- No risk that the investment will be frozen as you are the beneficial owner with the right to buy, sell or hold the bonds
The development of the direct bond market in Australia over recent years has seen a number of managers begin offering services that streamline the process. FIIG provides investors with access to Australian and international bonds in parcels starting from $10,000 (with a minimum portfolio balance of $50,000) through the ‘DirectBond’ service, with a universe of in excess of 300 bonds from which to select. This allows private investors to build their own portfolios, including SMSFs and individual accounts, according to their own risk and reward parameters.
3. Managed Portfolio (professionally managed direct portfolio)
The third way to invest in bonds provides investors with the best features of indirect and direct ownership through an Independently Managed Account (IMA). Importantly, holding bonds through an IMA provides investors with professional portfolio management, while retaining beneficial ownership of the bonds.
Many investors, especially those who are time poor, require assistance to manage the day to day requirements of managing a bond portfolio efficiently, including but not limited to tasks such as monitoring markets, undertaking credit research, selecting bond opportunities, governance and transacting.
The key benefits of an IMA are:
- Expertise – Unlike buying bonds directly you have access to a team of bond experts who know and understand the sector.
- Diversity – IMAs can hold a diverse range of bonds with the portfolio manager able to invest from $10,000 per bond, from a minimum $250,000 investment
- Direct ownership of assets in the portfolio – the investor retains direct ownership of the bonds, rather than units in a fund that owns the bonds.
- Regular and timely income - Investors can choose to have their income distributed to their nominated account or automatically reinvested
- Full transparency - Access to monthly portfolio reporting and documentation in one place including exposure, valuation, performance, transactions and income, providing better insight into performance and risk.
- Access to institutional bond prices – IMA investors are able to transact in the institutional bond market efficiently.
FIIG’s Managed Income Portfolio Service (MIPS) is the first in Australia to offer direct and diversified professional fixed income management for wholesale investors the minimum entry level of $250,000. MIPS offers four Investment Programs – Conservative Income, Core Income, Income Plus and Inflation Linked – all tailored to appeal to a wide range of investors risk appetite and investment goals.
Fully customised programs are available for investment amounts in excess of $5 million.
First Principles
Like any investment, the underlying strategy and process of an IMA is fundamental to achieving benchmark outcomes. Investing successfully in bonds through an IMA requires a manager that adheres to a number of first principles that are absolutely focused on preserving clients’ capital and generating yield and, therefore, income.
The first principles of any IMA should include;
- Maximise diversity - Lower concentration risk by spreading investment exposure across a wide range of corporations whose economic performance is not correlated.
- Analyse and invest in issuers with strong credit metrics – An investment grade credit rating helps identify a strong credit, but an unrated, or sub investment grade bond will still represent a worthwhile investment where the stress tested business model is still capable of servicing the debt
- Derive portfolio absolute and relative value - Investing in the highest yield for the minimum credit risk taken.
Underneath these first principles should be a detailed, documented investment process that provides the framework for effective investment decision-making.
Investment Process
The IMA investment process begins firstly with a thorough analysis of each company to get an understanding of the asset at a micro economic level, and the factors that would contribute to a change in price, either up or down. This is overlaid with an analysis of factors that affect the asset at a macro-economic level, usually being both sovereign, international and domestic economic performance and demand for monetary assets that drives base benchmark interest rates, and general appetite for credit spreads.
Secondly, the portfolio is constructed, taking into consideration, two main factors:
- The maximum exposure limits to each capital structure level – senior, subordinated and hybrid, and each credit rating level.
- Setting a target portfolio duration*. This is determined by the current view on the direction of interest rates and the shape of the yield curve.
The portfolio management team then selects assets from the approved universe to achieve both capital structure exposure and the targeted duration. Funds will be invested into those assets, and combination of assets, that offer the highest relative and absolute return. The portfolio management team then monitors the market for changes, whether for duration or credit performance, and rebalances as required.
For each portfolio, risk limits are in place, delivering unique risk and return profiles, with risk reduced through exposure diversification. Risk considerations are complex and encompass the following four key elements:
- Capital structure position
- Credit worthiness
- Tenor of investment
- Liquidity
Each element is an integral determinant of return, which is expressed as a yield. To compare any investment to any other, no matter where it sits on the yield curve, we express risk as a credit margin over bank bills (swap).
Analysis of the asset pool will include examining particular industries, and companies within industries, to identify bond correlation, for possible exclusion from the ‘possible’ investment list.
The team then finalise the asset pool of possible bonds they can use to construct the portfolio. The pool is constructed to deliver a maximum return for minimum risk and maximum liquidity. The process is constantly repeated as any new information is released, or any change in forecasts is made by the portfolio management team resulting in a requirement to rebalance the portfolio.
FIIG’s four different IMA programs have different minimum and maximum limit exposure metric boundaries, documented within the Program Investment Mandate, , that include but ar not limited to:
- Investment grade (IG) senior debt, IG subordinated debt and unrated debt
- Individual security and total portfolio tenors (or maturities)
- Product type: fixed rate bonds, floating rate notes and inflation linked assets.
Source: FIIG Securities
For example, in the flagship “Income Plus” program, sub investment grade and unrated debt (high yield) is limited to 75%. To allow for new opportunities and as a precaution, the team will allocate less than the maximum to this sub set. The current allocation to to high yield is 60%. Historically, during 2016, the minimum exposure held in the high yield sector in the example portfolios has been 40% and the maximum has been 70%.
The Income Plus investors have on average 31 bonds per $500,000 portfolio, made possible by the $10,000 minimum per bond available through the DirectBond service. Diversity is the key risk management tool for fixed income portfolios
For example, when the portfolio management team alters the unrated exposure, the programs that invest in that space, being the Income Plus and Core Programs, all will move in unison, according to their proportional exposure. The Core Income Program for example, will always hold 20% of the high yield exposure that the Income Plus Program does, so currently it holds 12% exposure
The MIPS investment process is applied to each program, and to each investor IMA portfolio uniformly. This process delivers investors the same exposure derived from the same optimized top down and bottom up research and analysis.
The approach has delivered the following returns to 31 October, 2016:
Source: FIIG Securities
Past performance is not a reliable indication of future performance. Returns are “Net” of custody and investment management fees; and, based upon a current average portfolio size of approximately $AUD400,000.
Governance and oversight
The FIIG IMA has three levels of governance:
- Portfolio Management Committee – an internal committee that oversees risk management processes, the performance of the IMA and provides consultation in difficult market conditions.
- Supervisory Management Committee – the majority are external independent members that review portfolio exposure, turnover and performance. This committee also serves an internal audit and approval role.
- Auditors – who undertake annual audits of both the investment portfolio as a whole and the custodian, that is regulated by ASIC.
Conclusion
Bonds are an increasingly important part of any investment portfolio. For a long time they have been almost the exclusive domain of institutional investors. However, more investors and advisers now understand and appreciate their value and importance within an investment portfolio for the purpose of improving diversity..
New access has been opened to both retail and wholesale investors with an opportunity to either invest direct or within a managed portfolio. As a result, a source of new value and stability has come within reach of Australian investors.
Individual investors can now access the institutional market and invest direct from $50,000 or through the bond IMA from $250,000. We consider the IMA the ‘platinum’ option delivering a comprehensive service designed to outperform.
*Modified duration
Modified duration is a measure of a portfolio’s sensitivity to movements in interest rates, and the percentage change in a bond's price for a 1.00 percent change in the whole yield curve. For example, a portfolio with a three year duration would lose 3% if that interest rate curve moved up by 1% across the whole curve. Conversely, a 1% downward move across the curve would result in a 3% gain. In reality, the curve rarely moves in parallel and it will typically move by different amounts for different tenors. This is what we have seen recently with the long end of the curve (5+ years) moving by more than the shorter end, less than five years.