Tuesday 07 October 2014 by Craig Swanger Opinion

High yield USD portfolio earning 7.2%

Two weeks ago we highlighted a conservative strategy that profits from a falling AUD/USD exchange rate. The article showed a portfolio of investment grade USD Bonds earning 3-4% p.a. (see “Australian Dollar doldrums - how to use bonds to profit from a falling Aussie dollar and earn 3-4% p.a.”)

This note shows how you can invest in high yield USD bonds and earn a high 6-8% p.a., and still profit from a rising USD (falling AUD).

This high yield strategy takes more credit risk, but it also provides a duration risk hedge. If yields are going to rise globally, it’s going to start in the US. And if this happens, history tells us that the USD is likely to rise further. So for Australian investors wanting to reduce duration risk but not reduce total returns, high yield USD Bonds provide a smart income producing strategy. Specifically:

  1. High yield bonds are less vulnerable to rising bond yields ( they have lower “Duration Risk”)
  2. USD Bonds provide a natural hedge against Duration Risk where the US economy recovers faster than the Australian economy
  3. High yield USD Bonds will still offer the same USD exposure in the event of a fall in the AUD against the USD
  4. High yield USD Bonds of Australian companies are better value than their US equivalents simply due to the home bias that US investors tend to have

We look at each of these points below, but as always: High yield bonds come with higher risk than investment grade bonds. There is no such thing as a free lunch, even with bonds, so if you want the USD exposure but not the credit risk that comes with high yield bonds, please see our conservative portfolio suggestion above.

  1. High yield bonds are less vulnerable to rising bond yields

For investors wanting to reduce their Duration Risk, high yield bonds offer a strong proposition. As shown in Figure 1 from Russell Investments, high yield bonds have performed well in times of rising rates. This is because the trading margin ( the extra interest above the base bond rate that investors earn for taking the extra credit risk on these bonds) provides a buffer against repricing as rates rise.

high yield bond performance graph

Source: Russell Investments

Figure 1

…particularly if US rates rise faster than AU rates

The US economy is coming off a very low base in terms of both economic growth and interest rates. If rates rise faster than markets expect, US bond yields will rise, and typically that means a rise in the USD against other currencies.

At the same time, Australia’s economy struggles to replace the jobs lost in the mining investment slowdown and has hit its highest level of unemployment in 12 years. Net mining investment is expected to fall from contributing 1% to Australia’s GDP in 2011 and 2012, to -0.6% in 2015. Jobs created by the mining investment boom peaked at 3% of total employment and expected to fall to 1.5% by 2016.

Figure 2 shows the divergent paths of the US and Australia’s unemployment data. Australia’s unemployment is on the rise passing through 6% for the first time in 12 years, while US unemployment has fallen from 10% in 2010 to be at just 5.9%.

US labour market chart

Figure 2

The High Yield USD Bonds strategy works best when the US economy continues to surprise on the upside and the AU economy on the downside. This will put pressure on US bond yields to rise quickly, and put upward pressure on the USD vs the AUD. This will have the effect of reducing the value of your USD Bonds by 1-5% depending upon their Duration. But higher US rates relative to the rest of the world will push the USD higher and thus we expect will hedge the losses on the duration risk of the fixed rate bonds, leaving you with a high yield.

1. High yield USD Bonds provide a potential Duration Risk hedge

Bond prices have already priced in future expectations of rising rates by central banks like the US “Fed” or the RBA. But some investors are concerned that markets have not fully priced these in. That is they believe the Fed will increase rates faster than the market is currently anticipating. The risk of rates rising faster than the market expects and therefore the yield curve shifting upwards is known as “Duration Risk”.

  1. High yield USD Bonds will still offer the same USD exposure in the event of a fall in the AUD against the USD

Two weeks ago we showed a conservative USD Bonds strategy in which the investor takes a position in investment grade rated USD Bonds, gaining an exposure to further increases in the USD against the AUD ( falls in the AUD vs the USD) while earning 3-4% p.a. A rise of 10% in the USD in a year would result in a 10% gain on the investment, plus a 3-4% yield. Conversely a fall in the USD of 10% would result in a 10% loss, reduced somewhat by the 3-4% yield.

High yield USD Bonds will offer the same upside (and downside) but will offer a higher annual yield of say 6-8% p.a. This higher yield comes with higher risk, as always.

  1. Australian companies’ US Bonds offer better value than their US counterparts

The Bloomberg Global High Yield Corporate Bond Index, which has a duration of 4.29 years, and average credit rating of B+, exhibits a current weighted average yield to maturity of 6.48% across the 2,149 issues measured.

Many Australian companies, with USD HY issues, trade substantially wider than the index. As shown in the table at the end of this report, in some cases these bonds are offering over 200bps more than the Index. A primary driver of the relative “cheapness” of Australian companies in USD, is the simple home bias US domestic investors apply to their portfolios; investors prefer to hold household domestic names, over foreign companies which are less well known.

A higher yield, more effective way of investing in USD

As we’ve said previously, some Australian investors use unhedged international shares for the purpose of gaining an exposure to a falling AUD. That’s an ineffective hedge in our view as a falling AUD is often correlated with a “flight to safety” when equity markets are falling, so the hedge only works when investors stay exposed to the falling equity market. Other investors simply buy US Dollars, but find they are earning no interest while they sit and wait for a fall in the AUD.

We have another idea. A well diversified portfolio of high yielding USD Bonds shown below yields around 7.20% p.a. in USD. In other words, for every USD100,000 invested, you will receive USD7,200 per annum on average. It’s worth noting you need $200,000 to invest in two of the bonds and minimum investment for this portfolio is $430,000.

Note: The Bloomberg USD High Yield Corporate Bond Index is a rules based, market value weighted index engineered to measure publicly issued non-investment grade USD fixed rate, taxable, corporate bonds. To be included in the index a security must have a minimum par amount of USD250m.

high yield USD fixed rate bonds chart

Table 1: USD Bonds Portfolio Illustration

Clients that have followed our recommendations on USD Bonds over the past year have seen earnings in the range of of 10-20%. See “Foreign Currency Bonds deliver windfall to investors” also published in this edition of The WIRE on how they earned these returns.

This means you can invest in USD bonds, offering a hedge against a fall in the AUD, but earn up to 9.10% p.a. rather than the zero interest USD bank accounts offer. And unlike using international shares as a way of getting an exposure to the USD, with USD denominated corporate bonds you have a simple, transparent and low capital risk investment with the security of some of Australia’s largest companies.  

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