Recently, I had a client ask me if he should wait until yields rise before buying bonds. It is a common question, here are my thoughts. We also suggest a $1 million portfolio
Client: I am comfortable with the FIIG offer etc. My issue is the stage of the cycle across many asset classes including debt. I am still working through this macro issue and may decide to recommend that the family “sit on its hands” while we wait for better entry levels. Happy to hear your thoughts.
I take your point about where we are in the credit/economic cycle. However the risk then becomes what opportunity cost are you willing to bear on an uncertain timeframe and outcome?
Answering this question given the over-arching ‘megatrends’ driving yields, I have been asking clients to think about the 4 D’s:
The four combined should keep yields lower than they have been historically and also simply the weight of cash looking for secure, consistent returns is another driving force, pushing yields down.
Sitting in cash is a pretty risky strategy in my opinion. I don’t see yields rising any time soon and we’ve witnessed recently US 10 year Treasury yields compressing as hope of the Trump inflation trade diminishes.
Look at Figure 1 of the AUD five year swap over the last 20 years or so.
AUD five year swap from 1998 to 2017
I know rates have declined generally but the important thing to look at is what happens during correction type periods – rates actually fall a lot. At the same time, credit spreads also widen as shown in Figure 2 where spreads have widened about 350 points across the investment grade spectrum, but the underlying swap rate also fell by about the same amount.
AUD Itraxx Investment Grade Credit Spread index from 2004 to 2017
The net effect is generally one of offsetting impacts; the bond prices themselves don’t tend to move much. Investors will generally look for safety at the time of a correction and gravitate towards bonds and cash. The challenge is to pick a range of bonds which give you the security of being paid back plus the liquidity to be able to sell them in a fearful market.
The answer in my view is a properly diversified portfolio. This will enable you to increase returns over cash from the immediate, but then also allow you to take advantage of a recession or asset price correction by liquidating parts of your portfolio to free up cash to take advantage of those opportunities.
How do I get a properly diversified portfolio, you ask?
The way to do that is to invest in a portion of really conservative bonds such as major bank senior debt, or even government bonds. They may be much lower yields but look at that as a hedge, then use the rest of the portfolio to increase the overall returns.
In Figure 3 below, look at the AUD/USD exchange rate movements in 2008/09 which went from over 97 cents in July 2008 to 60.5 cents in Oct 2008.
Investing a portion of your funds into high yield USD bonds would act as an AUD hedge as well as provide high income.
AUD/USD from late 2007 to early 2011
The sample portfolio gives you a yield to maturity of 5.04% and a running yield of 5.70%, which is ~2.5 times the return on cash but also gives you the benefits we have described above.
The portfolio contains approximately 30% of government or semi-government bonds which give the downside protection, 26% high yielding USD bonds which really increase the overall yield and income (and hopefully despite being high yield will be hedged in AUD terms in a recessionary type environment by the currency effect noted in Figure 3), and the remaining 38.4% in AUD investment grade bonds (which history tells us have defaulted only three times in the last 30-odd years) plus a small allocation of 5.6% to AUD high yield, again to pick up the income.
The weighted average term to maturity is relatively long at 9.5 years, but given the higher yielding bonds providing high income, the duration (interest rate sensitivity) is relatively low at 4.34 years.
The overall design is for different parts of the portfolio to perform at different times, resulting in an overall stable capital outcome and at the same time a large pick up over cash yields.
Source: FIIG Securities
Prices accurate as at 29 August 2017 but subject to change