FIIG Research started publishing its view on the relative value of owning USD denominated corporate bonds back in August 2014. At that time, the AUD/USD exchange rate was 94c and we wrote to clients suggesting 75c was fair value. All the major banks had 85-90c as forecasts.
A lot has changed in that time. The US has continued on its recovery path, with business investment in particular driving strong economic results.The recovery is still fragile, but certainly compared to the rest of the world, relatively solid and reliable.
At the same time, Australia’s economic outlook has weakened considerably. Commodity prices have fallen further, business and consumer confidence is down and while retail and construction data has shown brief signs of life, activity needs to be sustained to bring confidence back.
With the US economy strengthening further and the Australian economy weakening, we revise our outlook for the AUD/USD exchange rate to 65-70c.
It’s now 78c and even the majors have forecasts down to 70c. With many of our clients having bought USD corporate bonds well above 85c, the most common question we are getting these days is “What level does it make sense to consider selling?”
In this article we take a look at the reasons why investors should hold foreign currency corporate bonds. We show that there are three major investment strategies, only one of which suggests you “should” sell simply based on currency movement.
3 key investment strategies for investing in foreign currency corporate bonds
Investing in fixed income in a foreign currency requires a similar plan to investing in fixed income in your own currency. You need to understand why you are investing and therefore at what point it no longer makes sense to stay invested.
Aside from the normal benefits of investing in bonds (regular, secure income and lower capital risk than shares), there are broadly three reasons to own foreign currency bonds:
- Credit diversity: A different economy or exposure to different sectors than Australia offers means investing in offshore bonds can provide diversification, lowering portfolio risk.
- Relative income: Sometimes one market will offer a higher “spread” (better returns) than another.
- Relative capital value: Warren Buffett’s favourite strategy – buy good companies for good value. If buying in a foreign currency, this holds just as true but you need to consider both the relative value of the bond AND the currency. If the bond rises in value but the currency wipes out the gain, you’ve not bought for good value in hindsight.
These strategies are not mutually exclusive. That is, you should be considering relative income and capital value even when investing offshore for credit diversity. But it’s about the main reason for holding a bond. If someone has invested in USD corporate bonds, for example, to get exposure to the healthier US economy, they would be more likely to hold that investment until the economic advantages fade, not selling just because of a move in the currency. Similarly, if they are investing for better income, the currency level is less relevant. But if investing because the currency itself makes the bond great value, there must be a level at which it no longer makes as much sense to hold that bond.
Relative value when considering currency values
So let’s consider the “Relative Capital Value” investment strategy in more detail to answer that question we are currently getting from clients that have made big gains on their USD investments.
Relative value requires an assessment of return and risk. For an investment to be good value, it means it offers good return prospects relative to the level of risk of the investment. Risk is not the same as volatility as many investment specialists will suggest, but also includes overpaying for an investment; overestimating that investment’s earning potential; liquidity risk, that is, not being able to sell when you want to; and investment-specific risks (called “idiosyncratic risks”).
So when looking at currency levels and considering relative value, the assessment is highly subjective. There are a host of historic data points and quantitative analyses that can be done, but past performance only gives us an idea of what happened last time we were here, not next time.
To have a plan, however, one has to form a view. Based on our view of global markets, as outlined in our 2015 Smart Income Report, the below gives a framework of relative value of the world’s major currencies and a sense of whether the relative risks and value are rising or falling (as shown by the arrows).
Same old boring message
At FIIG we believe that regardless of whether you use a financial planner or not, you are the only one ultimately responsible for whether you succeed or fail when planning your future investment income. So that means you need to draw on reliable independent sources to form that view, and then build a plan. We repeat this call to action: “have a plan” over and over, and it is no doubt boring, but the old adage is undeniable true: “if you don’t have a plan, you guarantee that you won’t achieve your goals”. So, what is your plan for including foreign currency bonds in your portfolio?
For more information, please call your local dealer.