Investors are having to adjust to the riskier nature of equity investing as more and more companies reduce, cancel or defer dividends. Those with a truly diversified portfolio should however be cushioned from this loss in income, thanks to the regular cashflow from a low risk bond portfolio.
This document has been prepared by FIIG Investment Strategy Group. Opinions expressed may differ from those of FIIG Credit Research.
Retail investors in Australia have historically been lured by the attraction of regular dividend income streams and the associated franking credits of equities. The recent dividend cuts, deferrals and cancellations have highlighted the risk associated with this strategy at the worst possible time as consumers grapple with the wider economic impact.
Dividend tide receding
The sage of Omaha, Warren Buffet once said, “only when the tide goes out do you discover who has been swimming naked”. Investing in defensive assets such as high grade bonds is not as exciting as riding the wave of the equity, however, it does provide a cushion during difficult times. In March this year, Blackrock produced the chart below which shows how bonds can provide diversity during an equity sell-off.
The dividend tide goes out
Banking regulators have been working hard since the last financial crisis to ensure banks have a sound capital base, noting that discretionary payments such as dividends on shares and coupons on hybrids should be deferred if it means preserving capital.
Just this week large dividend payers NAB and ANZ joined a number of other institutions in reducing and deferring their dividends. Other companies to have done so include Bank of Queensland, Sydney Airport, Qantas and Harvey Norman. We expect many others will follow suit.
It is important to highlight that the bonds issued by these corporate entities have continued to pay their coupons, which are contractual obligations.
Equities as an asset class carry homogeneous risk. Equity is always ranked at the bottom of the capital structure and therefore carries the highest risk. Bonds however allow investors to invest across a spectrum according to their risk appetite from more defensive government bonds to higher risk high yield or unrated bonds.
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Choose your own adventure with bonds
The aim of diversification is to optimise the return of a portfolio while maintaining risk within a tolerance band by varying exposure to various asset classes. As such, consideration needs to be given to both the return of and return on capital. Bond prices just like share prices do move around, however, unlike equities, bonds have a fixed maturity date when the full par value of the investment is returned to investors.
Managing the likelihood of this return of capital is the accepting of the level of credit risk an investor wishes to take.
There are various considerations that allow bond investors to build a portfolio that suits their risk tolerance. For example, those with a higher risk tolerance can invest in high yield or unrated bonds, that tend to exhibit equity like volatility and risk. Investors wanting to add more defence to their portfolios should consider Australian government or Australian semi-government bonds. Of course, there is a broad range of options in between.
Below is a reminder of risk categories to consider when investing in bonds. This list is by no means exhaustive, and there are other factors that should be considered such as the maturity profile and percentage allocation to individual bonds when building a portfolio.
The recent market correction and extreme volatility have again highlighted the importance of the inclusion of bonds in investment portfolios. Aside from diversification, the two main reasons for owning bonds in a portfolio are income generation and principal protection. The recent dividend cuts by blue-chip companies is a good reminder that dividends should not be considered as annuity like income.
At present there are a number of bonds trading at either attractive prices or with strong relative value, presenting an opportunity for existing and new bond investors to diversify their investments. In investment grade bonds we are seeing opportunistic trading in bank sub debt and semi-government issued debt. In high yield, there are opportunities in bonds issued by corporates with strong liquidity on balance sheets or those in industries less affected by Covid-19 shutdowns.
Please talk to your Relationship Manager to discover what is currently on offer as availability can change quickly.