It has been a rocky couple of months in bond markets in particular, as rates broadly climbed off their lows to recent highs (which means prices fall), before peaking in late October and slightly recovering.
In the 2 months since the last update this has meant that yields are generally about 0.25% higher than previously, which has negatively affected the longer dated government and investment grade bonds, which make up 42% of the portfolio.
In addition, the relative yields in the AUD and USD government curves have converged slightly, putting upward pressure on the AUDUSD exchange rate, which is also to the detriment of the portfolio. The exchange rate started the period just over 0.67c and ended at 0.69c. With 27% of the portfolio denominated in USD, this was also a detractor from the period end valuation.
With this double whammy, the portfolio saw the returns come off the 8.90% p.a. highs of August to 7.68% p.a. overall, which considering both market measures went against me is still a very positive result. It is important to remember that the portfolio is still 66% investment grade bonds, and as such focused on capital preservation.
It was a busier period than usual for trading, as the external market provided opportunities that I took.
Firstly the new Pacific National 10 year offering looked very attractive against all other equivalents, so I switched the current holding on the old 2027 maturity for the new extended 2029. This realised a 9.15% return on the 2027 bond, held since the start of the portfolio in August 2017.
Secondly the Axsesstoday position paid back its capital in full, plus accrued interest. This was a fantastic result given the company had been in administration for the best part of six months, and the outcome was not certain. This proved the value of being as high in the capital structure as possible (these notes were secured, albeit subordinated to the banks but benefiting from a cushion afforded by unsecured notes) in riskier high yield investing, as unsecured creditors expect to get back only about 34c/$. I used some of the cash for the trade described below.
Thirdly, Virgin again tapped the over-the-counter (OTC) bond markets for a 5 year USD senior unsecured bond. This looked attractive against the rest of their funding curve, with an 8.125% coupon. I switched out of the Armour 8.75% AUD bond, taking a small profit and an annualised internal rate of return (IRR) of 9.33%, as I believe that Virgin is a stronger credit and the drop in yield is worth the lower risk. I upsized the position by approximately A$9,000, deploying some of the portfolio’s spare cash.
Frustratingly, Virgin then went on to issue a simple corporate bond listed on the ASX, unexpectedly upsizing this deal from $150m to $325m. The excess supply affected the existing bonds, notably the AUD 2023 and 2024 lines, which fell in price approximately $3. The bond above is currently mid marked at 99.40, slightly under the issue price.
Outlook this Christmas:
Yields have declined again in November as the recent news flow around a positive trade deal between the US and China has receded into the reality of the unrest in Hong Kong and the real gap between both sides’ expectations.
Economic data is gradually deteriorating, particularly in Europe, where Germany is already in a manufacturing recession.
The main question to ponder through this period of rising yields has been whether or not to take the profits on the longer duration, higher quality bonds and move into some higher yielding securities. The portfolio at current market yields has a below target yield of 4.45%*, mainly due to the 29% held in government and semi-government bonds, all at or around 1% yield to maturity (YTM).
On balance, my view is that while inflation (due to slight US wages growth and general commodity price uplifts) may rise slightly in the next few months, this is the calm before the storm, and we may well see further reductions in growth and inflation as we head into the early part of next year.
I have therefore decided to maintain the duration holdings in the portfolio for the time being, until it becomes clear that we are out of the woods. Remember, the government bonds are also the portfolio’s reserve of liquidity should we see a sharp risk off period, when I will look to sell them and pick up quality assets that have become cheap. Moving into lower rated corporate exposures with lower liquidity would force me to miss this opportunity.
|Return since inception (Aug 2017) p.a ||7.68% |
|Purchase Yield to Maturity ||5.13% |
|Market Yield to Maturity ||4.45% |
|Running Yield ||5.70% |
* Note the previously quoted YTM was the purchased yield to maturity, which is what the portfolio will realise if held as is from the bonds when purchased. As I have had many enquiries from prospective clients about investing in the portfolio I have included the forward yield at current prices to give an idea of what can be expected if the portfolio was purchased today.
Earn over 6% pa* with Corporate Bonds.
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