Tuesday 27 January 2015 by Elizabeth Moran Trade opportunities

Best bonds right now

A New Year, volatile financial markets and increased geopolitical tensions will mean many of you are reassessing your portfolio allocations. Do you have enough defensive assets? Is the mix right to meet your objectives? We take a look at the best value bonds right now.

Over the last year we’ve seen returns on offer continue to grind lower. What was available a year ago looks nothing like what’s on offer now. Interestingly, recent inflation figures from the UK and New Zealand point to sharply lower inflation in part due to greatly reduced oil prices. Because a lower fuel cost will cut the price of distribution, it will put downward pressure on the price of most goods and services. Central banks would likely respond to this by cutting interest rates even further where they can, with major implications for bond holders.

This will be partially offset in Australia by the recent devaluation of our dollar which will make imported goods more expensive. Despite this, deflation remains a scary prospect for investors who are reliant on income from their investments. In a deflationary environment, returns across all asset classes would decline sharply. Bond yields would continue to fall but, importantly, fixed rate bond prices would rise even further. Fixed returns would be highly sought after.

Depending on your view of interest rates, you may want to reconsider your allocations. I’ve compiled a list of what I consider to be the best value bonds right now.

Retail bonds

I’ve chosen one fixed, one floating and one inflation linked bond. For investors wanting to shore up income, the low risk National Wealth Management subordinated debt looks attractive, paying income of over 6%. While yield to maturity is less attractive at 3.67%, with only 18 months until the likely first call (the first opportunity the bond can be repaid) it’s a good short dated option.

The other two bonds show progressively higher expected yields to maturity given longer terms. If you think interest rates will rise more than what the market anticipates, you’d have a preference for the floating rate Dalrymple Bay Coal Terminal bond.

The third bond, Sydney Airport, is a long term FIIG favourite which is already held in many portfolios. It will protect in the event of a spike in inflation. This bond will also help protect in a deflationary environment given the 3.28% margin it pays over the Consumer Price Index (CPI). If the CPI turned negative, investors would be able to rely on the margin for income even though the capital value of the bond would decline. Under these conditions, the higher the margin, the better. Of course higher margin inflation linked bonds are rewarding investors for higher credit risk which needs to be considered before you invest.

All three bonds are investment grade and as retail bonds, are available to all investors.

Wholesale bonds – Domestic, investment grade

If you qualify as a wholesale investor, the range of bonds we can offer you is much wider (see Are you a retail or a wholesale client?).

Quantitative easing (QE) in Europe means there’ll be increased liquidity in the market and we expect both the AXA SA and Swiss RE older style Tier 1 hybrids to be called in the next couple of years, making both of these bonds attractive. They both offer over 4.5% yield to first call.

The Rabobank longer term fixed rate bond is a very good investment if you think we’re headed for a deflationary environment or a long period of very low interest rates. It’s highly rated and will provide a known income for many years.

The Ale capital indexed, inflation linked bond is highly sought after as it is very highly rated, with a projected yield to maturity of 4.51% (assuming inflation at 2.5%). It remains a top pick, when we can source the bond.

Wholesale bonds – Domestic, high yield

Over the last year investors wanting to increase income invested in high yield bonds. High demand has driven prices higher and yields lower. In some cases the incremental return you receive over lower risk rated bonds looks too thin.

For a long time I’ve been a fan of the Qantas bonds. Even though the yields are now less than 6%, they still offer good returns in a low rate environment. Of the FIIG originated bonds, I like CBL because of its business model and the fact that the main operating company is rated investment grade. While the table lists yield to maturity, CBL bonds can be called early after three years at $103 and four years at $101.50, so, if you are interested, its best to ask for a yield to first call return as yield to maturity may be overstating the return.

Wholesale bonds - Foreign currency

The best value foreign currency bonds continue to be those issued in USD and Sterling bonds. Returns available in EURO and YEN are very low, much the same as interest rates in those countries.

Below are a range of bonds in USD and Sterling. The Virgin Australia USD bond is high risk and thus pays over 7% yield to maturity, while the Macquarie Capital Funding Sterling bond is also sub investment grade as the higher yield to maturity implies.

If you are thinking about investing in foreign currency bonds it’s important to realise you are also taking currency risk which may have a positive or negative influence on your return.

For more information, please call your FIIG representative.

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities. For more information, please call your FIIG representative.