As published in The Australian on 13 June 2017. Prices updated and republished 21 December 2017.
If you are concerned about another major stress event, there are bond strategies that work to preserve capital but also deliver much needed higher returns. Here are five possible strategies
Altair’s surprise announcement last week that it had sold down its share fund and returned cash to investors had other fund managers disclosing that they were holding significant allocations to cash.
I doubt they are the only ones. Where do you invest when you are worried about a correction and everything looks expensive?
Cash deposits are certainly an option with the government guarantee of up to $250,000 per institution, per entity, preserving capital, which is a key objective if you think there’s going to be a correction. However, deposits are paying very low returns with a one year term deposit from a major bank paying around 2.4 per cent per annum.
Many Australian investors hold too much in cash and too much in shares, overlooking bonds that sit between these two assets classes in terms of risk and reward. Typically an Australian corporate bond portfolio will provide 1 to 3 per cent per annum over term deposit rates, throughout the economic cycle, and with greater certainty than shares.
If you are concerned about another major stress event there are bond strategies that work to preserve capital but deliver much needed higher returns. Some possible strategies include:
1. Invest in short dated bonds with less than 18 months to maturity
If there is 18 months or less until maturity, there is greater certainty that the company is still going to operate at maturity of the bond and, as an investor, you will have capital repaid to you. While credit risk – the risk that a company may default on interest or principal – still exists, you will earn higher returns when compared to deposits.
Three bonds with less than a year until expected maturity include personal finance provider, Cash Converters, Alumina and Downer Group. Cash Converters is a non rated, higher risk fixed rate bond with a yield to maturity of 7.27 per cent until maturity in September 2018. Alumina, a sub investment grade fixed rate bond matures in November 2018 with a yield to maturity of 4 per cent, while the lowest risk of the three, Downer also matures in November with a yield to maturity of 2.94 per cent. Returns typically range between 2.5 and 7.0 per cent per annum for these short term corporate bonds.
2. Invest in short dated, highly rated floating rate bonds
This is a common tactic for large corporations and middle market investors such as charities and schools. Floating rate bonds pay interest linked to a benchmark, which is adjusted quarterly. This largely removes interest rate risk, associated with rising interest rates.
Institutional investors would typically invest in the highly rated, highly liquid bonds from major banks and other very strong corporations. For example, an Australian dollar denominated bond by global IT company Apple, which matures in August 2019 has a yield to maturity of 2 per cent per annum. All of the major banks are common issuers of senior unsecured bonds. National Australia Bank has a senior floating rate bond maturing in three years with an expected yield to maturity of 2.38 per cent per annum.
3. Take a three year view
Three years is still a relative short term view in bond markets. There are around 40 bonds available from $10,000 per bond in this category that are both fixed and floating, investment grade and non investment grade. There are many more in higher minimum denominations.
Yields available range from just over 3.07 per cent per annum for a Qantas fixed rate bond to 5.44 per cent per annum for out of favour Adani Abbott Point Coal Terminal. The coal terminal was previously owned by the Queensland State government and has been in operation for more than 30 years.
4. Use a mix of corporate bonds with staggered maturity dates to earn higher returns than deposits and match your anticipated cash flow needs with the bond maturities
In this way, you can use a number of bonds to generate required yields over a five year term.
5. Invest in Australian Commonwealth government bonds issued when interest rates were higher four or five years ago
These are fixed rate bonds that have risen in price from when they were issued because of the high, fixed rate of interest that they pay, which cannot be changed over the life of the bond.
For example, there is a Commonwealth government fixed rate bond due to mature in July 2022, around four and a half years from now. It has a very low yield to maturity of 2.12 per cent per annum, which isn’t very attractive. When it was first issued, interest rates were higher and so it pays a fixed rate of 5.75 per cent, per $100 face value until maturity. The bond price has risen to around $115.64 and the yield to maturity, based on the higher purchase price has declined to 2.12 per cent.
However, annual income on this bond is still high at about 4.8 per cent per annum based on the $115.64 purchase price. If you are of the view interest rates will be fairly stagnant in the coming year or two, you could invest in the bond for a short term and tap into the higher income with the intention to sell in 12-24 months. There is some risk in this strategy as prices move daily and many factors influence prices, but if, as markets expect, we are in for a relatively stable interest rate regime, this could be a strategy to consider.
Source: FIIG Securities
Prices accurate as at 21 December 2017 but subject to change
A couple of other reasons to consider Commonwealth government bonds:
- They outperformed during the GFC as investors fled other asset classes looking for a safe haven – potentially offsetting possible losses on some of your higher risk investments.
- Performance is not tied to the economic climate, so great diversification for your portfolio.
- If bought in the over-the-counter market, they are very liquid and easily tradable