We have recently run a series of webinars, showcasing our Credit Outlook for 2021 and the regularly programmed Introduction to Fixed Income and Building a Balanced Portfolio presentations.
Through all of these webinars, it was great to have lots of interaction with viewers, and lots of questions were asked.
It is often the case that when one person thinks of a question, others are also wanting an answer to the same thing, so one question helps many people.
In that spirit, we have compiled the most frequently asked, and (in our humble opinion) the most useful questions for publication to a wider audience, so that all may benefit from what a few have asked.
In no particular order, here we go:
Given the role of RMBS's in the GFC what makes current offerings palatable? Are CDOs (which were a problem exacerbated by incorrect ratings) still an issue?
Australian Residential Mortgage Backed Securities (RMBS) have always had one central feature that distinguishes then from their American counterparts which caused all the trouble in the GFC – the concept of full recourse.
Australian mortgages have recourse beyond the value of the secured property to the individual borrower, whereas the security on American mortgages is limited to the property alone.
This means the threat of personal bankruptcy beyond just losing ownership of the property in question means that Australians tend to prioritise mortgage payments above almost all other household expenses.
This in turn with our conservative lending standards (overseen by a well-respected regulator in APRA) and the structural protections inherent in the RMBS structures give us a large amount of confidence in these securities.
Indeed, in the history of all Australian RMBS, there has never been an un-remediated loss to any tranche rated by a ratings agency.
Typically, RMBS offer approximately 1% higher yields than a vanilla corporate bond of similar rating and tenor.
What are your thoughts on the current inflation narrative? Are central banks likely to step in if market rates get higher than expected?
We addressed the issue of rising rates and longer dated bonds in our article in the last edition of the WIRE – that can be accessed here.
Central banks globally, but of particular relevance being the US Federal Reserve and the Reserve Bank of Australia (RBA), have been unanimous in their views that the global economy is still weaker than the headline numbers are suggesting and that significant spare capacity, particularly in employment, still exists.
With these conditions, real sustained inflation is in their view unlikely to be realised and they will therefore keep their very accommodative monetary policies in place for an extended period.
Of course, there is a chance that the data shows a sustained global recovery more quickly than anticipated, and this may well follow that they will change their mind.
One important change to the narrative coming from the central bankers is that they will be looking for actual inflation to be over their targets rather than their previous measure of forecast inflation – therefore they are likely to allow the economy to “run hot” before potentially raising rates to put a brake on a fragile post COVID expansion.
However, it currently looks as though rates will be kept low for a number of years, and this should support even longer dated bond prices.
Remember, as long as the issuer remains solvent, which historically has been a very safe bet in Australian investment grade bonds, even long dated bonds will pay their coupons when due and return the principal at the maturity date of the bond. Therefore, holders of bonds to maturity can ignore shorter term fluctuations in bond prices and concentrate on the secure income stream.
How do inflation-linked bonds work? Are there likely to be more issued (CIBs and IABs), and do you include them in your recommended portfolios?
We published an article on how inflation linked bonds work here.
Most of these bonds were issued prior to the GFC, as part of the funding structures of Public-Private Partnerships (PPPs), to construct essential infrastructure such as railway stations, courthouses and jails and hospitals, to name a few.
In the period following, these projects were less common, and as such so were the financing structures. We currently have not seen a new inflation linked issue for over 10 years, and we do not expect many more if any to be issued in the near future.
This means that the existing inflation linked bonds are becoming scarce as they reach maturity dates and are repaid, usually being refinanced in this low interest rate environment with more traditional bank debt or more vanilla fixed or floating rate amortising bonds.
Despite the relatively low inflationary environment we have seen since the GFC, we believe there is a place for inflation linked bonds in every portfolio, as if inflation does rear its head, it will likely be too late to find the bonds required to get the protection due to their scarcity, and they also, due to them not being as mainstream, tend to offer slightly better value than a vanilla corporate bond of similar rating and tenor, so we like them from a relative value perspective as well.
How are foreign currency bonds dealt with, and do you recommend including them in portfolios for diversity? Are there any restrictions in dealing in foreign currency bonds?
FIIG now has a licence to deal in FX, and as such clients can now trade in foreign currency bonds and have full transparency over the fx rate used in any transaction.
FIIG has the capacity to accept AUD payments for the settlement of bond trades in the major global currencies, or indeed in those currencies if the client prefers to pay in a non-AUD currency.
Coupon payments can also be paid in either AUD or the currency of the coupon if not AUD.
Clients accept the FX risk of a foreign currency denominated bond position, and as such with this extra risk, foreign currency bonds are restricted to wholesale certified clients only.
There are a number of benefits associated with being classified a wholesale investor, which we will cover in a series of articles in the near future. The basic requirement to attain this certification is to have either one of:
- Net assets of >$2.5m
- Taxable income in each of the last 2 years >$250,000
What is the difference between an investment grade rating and a sub-investment grade rating? Are credit ratings revisited on a regular basis? Who gives a bond a credit rating?
There are many credit rating agencies but the most reputable, largest and well known are Standard & Poors (S&P) and Moody’s. These two are responsible for issuing the vast majority of credit ratings in the public bond markets.
Each have their own slightly different but basically identical scale of ratings, with slightly different nomenclature.
There is a clear distinction in the level of credit worthiness implied by a credit rating, divided by what is known as an Investment Grade rating. This rating is defined as one of BBB-/Baa3 or higher.
Ratings are typically reviewed on a regular basis, periodically when results are issued by the company in question, or something material changes in relation to the particular company or a condition which may affect its creditworthiness, for example a material change in the price of a commodity that derives the majority of income for a mining company.
These have been the major themes coming through in the questions we received during the webinar series.
If you have further questions please do not hesitate to get in touch with your FIIG Relationship Manager or our Client Services team.
We look forward to continue to educate, advise and empower investors in the direct fixed income arena.