Authors – Liz Moran and Leigh Winton
One of our recurring themes is to reduce risk in your portfolio. We make some suggestions in investment grade bonds in AUD and USD
We are now in the later stages of the credit cycle according to Mark Bayley in his Macro credit outlook: Mid-year update. At the end of the paper, Mark suggests eight themes which we will bring to you in coming weeks.
This week we start with his first – investment grade over high yield.
Few clients have a 100% investment grade portfolio as the returns are low at this point in the cycle. If the investment grade bonds have a short term until maturity, returns are likely to be even lower. For that reason, we don’t necessarily recommend you sell all your high yield securities, rather be comfortable with the mix and the high yield names you invest in. Moving up the capital structure to a guaranteed or secured position also helps risk management in high yield bonds.
Investment grade securities are perceived as much lower risk than high yield and statistically proven to be so over time. Credit rating agency, Standard and Poor’s publish an annual default rating table, specifically identifying the percentage chance of default given the credit rating and the term to maturity.
The most recent table is published below.
S&P Global Corporate average cumulative default rates (1981-2017)
This is an interesting table as it allows you to check the probability of default in your portfolio. By the way, ‘default’ doesn’t necessarily mean you’ll lose money as Thomas Jacquot explains in his note
‘A default is just the beginning – three case studies to illustrate some of the many possibilities’.
The row I tend to focus on is the ‘BBB’ rating, being the lowest investment grade. Running along the row, you can see that a BBB rated bond with a five year term has a probability of default of 1.70%, which is very low. Moving down that five year column, you’ll see the probability rises dramatically for BB rated bonds to 7.11% and for single B rated bonds to 17.88%.
Over time, investment grade bonds (BBB- and above) have proven to be safer investments than high yield, being BB+ rated or lower (including not rated at all).
Australian Dollars
In Australian dollars, our themes prefer defensive sectors like infrastructure, utilities and some financials. This is because these sectors tend to exhibit less volatility in stressed times, and consequently they perform relatively better than more cyclical or higher risk sectors.
Preferred Australian dollar investment grade bonds include both Sydney Airport inflation linked bonds. These bonds are for essential monopoly infrastructure that is the gateway to Australia and still able to provide strong returns of CPI + 2.20%pa for the short dated 2020 maturity and CPI + 2.78%pa for the 2030s.
Other infrastructure names to consider include – Adani Abbott Point Terminal, Australian Gas Networks, Asciano and Praeco. See the table below for more information.
Financials we like include the IAG floating rate subordinated debt with a first call in June 2024 and a yield of BBSW + 1.59%pa and the fixed rate Liberty 2020 bond with a yield of 4.41%pa.
Shorter dated RMBS are highly sought after offering floating rate coupons and a pick up in yield over other similarly rated financials. This is likely to compensate for probable illiquidity in the case of a stressed market.
Investment grade AUD
Source: FIIG Securities
Note: Inflation linked bonds assume CPI is 2.5%pa
Prices accurate as at 5 June but subject to change
US Dollars
Here are just a few investment grade USD bonds. There are also some options in euro and sterling.
Just last week we added healthcare group, HCA to the DirectBond list. HCA is headquartered in Nashville, Tennessee, and is the largest for-profit hospital operator in the US (by revenues) and a leading comprehensive, integrated provider of health care and related services.
The group currently operates 179 hospitals with 47,000 and 120 freestanding surgery centres. Almost 50 per cent of its hospitals are located in Texas and Florida, but HCA operates across 20 US states and in the United Kingdom. You can find its Factsheet here.
QBE is a firm favourite with a yield to call of 5.83%pa, exceeding other USD investment grade bonds on the list but be aware as it’s an insurer and the bond is subordinated it has a final maturity of June 2046
Investment grade USD
Source: FIIG Securities
Note: Inflation linked bonds assume CPI is 2.5%pa
Prices accurate as at 5 June but subject to change
Please contact your relationship manager or Portfolio Strategy Services if you would like to discuss your options.