Tuesday 21 July 2015 by Justin McCarthy Education (advanced)

Low risk plus high yield, a match made in heaven

Last week we ran two portfolios: a flight to quality or ‘safe harbour’ portfolio and a diversified unrated portfolio. This week we combine the two and demonstrate how they work in tandem, producing a diversified portfolio with 26 names whilst maintaining an attractive yield to maturity of 5.5%

canada geese

Last week we ran two portfolios: a flight to quality or ‘safe harbour’ portfolio and a diversified unrated portfolio. (To view these articles please see the links below). 

Having assessed the probability of default and the different characteristics of investment grade and sub-investment grade/unrated, we derived three simple rules for constructing a portfolio:

1. The majority of your portfolio should be investment grade.
2. The allocation to high yield bonds needs to more diversified than your investment grade portfolio to ensure you are not overly exposed to the default of any single bond.
3. As risk increases you must ensure you are appropriately compensated via higher return.

This week we combine the two portfolios and assess the characteristics of the combined portfolio using these three rules.

 Detailed below is the combined portfolio and some of the key exposure statistics: 
 
combined portfolio with exposure statistics
Rating Bond Type

Using the three rules above we note the following:

1. The majority of your portfolio should be investment grade.
 

• The combined portfolio is for a circa $550,000 spend, with 68% allocated to investment grade and 32% comprised of unrated bonds, or roughly a two-third investment grade and one-third sub-investment grade/unrated mix
• The allocations can obviously be changed to suit investor preferences
• The portfolio has a high allocation to AA rated (25%) and single-A rated (19%) bonds, as demonstrated by the left hand pie chart above
• We again highlight the attractiveness of the inflation linked bonds (ILBs) as high quality or ‘safe harbour’ investments. These capital indexed bonds (CIBs) and indexed annuity bonds (IABs) are both highly rated but are also removed from the volatility of offshore markets (e.g. China and Europe/Greece). Many of these ILB entities supply essential infrastructure and are backed by regulated, monopoly and/or government income streams. Further, they provide ‘duration’ or interest rate risk that is important in an overall portfolio setting (i.e. a countercyclical buffer against equities) with the added bonus of inflation protection and expected returns in-excess of 5%

2. The allocation to high yield bonds needs to more diversified than your investment grade portfolio to ensure you are not overly exposed to the default of any single bond.

• Highly diversified portfolio with 26 individual companies from various sectors
• No single company or issuer exposure over 10% and the larger exposures are all to investment grade names
• No high yield/unrated exposure over 2% (each allocated $10,000 face value), meaning that the portfolio is not overly exposed to any one of these higher risk entities that are added to enhance overall returns
• Diversified by bond type (with the ability to change to suit investor preferences):

o 45% allocation to fixed
o 20% to floating
o 19% to CIBs
o 16% to IABs

• The portfolio provides a good balance as well as significant inflation protection, while still achieving a high yield to maturity

3. As risk increases you must ensure you are appropriately compensated via higher return.

• An impressive indicative yield to maturity of 5.5% given the diversified nature and fact that the cash rate is just 2% and five and ten year swap rates are around 2.7% and 3.3% respectively
• The high yield/unrated component has a yield to maturity of approximately 6.7%, average trading margin of over 400bps and a running yield of almost 7.3%, which is viewed as appealing given where base rates are
• A high average trading margin across the entire portfolio of 255bps

Notes on the portfolio:

Where there is an issuer with a fixed and a floating option, the floating has been chosen (i.e. G8, McPherson’s and SCT). Investors not concerned by the prospect of rising rates could increase returns by replacing these with the fixed lines. Further diversification is also possible by including any of the three fixed Qantas sub-investment grade bonds.

As mentioned last week, a number of tweaks could be included to match individual preferences, including:

• An increased allocation to government bonds, the true ‘flight to quality’ asset, although this would likely see the yield to maturity fall
• Inclusion of residential mortgage backed securities (RMBS) as alternatives to floating rate notes. AA- rated RMBS with a weighted average life of eight years are available with trading margins of circa +220bps and BBB rated options with a five years weighted average life trade around +300bps
• Those worried by the prospect of rising rates could increase floating rate options, although much of the countercyclical buffer/smoothing effect detailed in the analysis above is provided by the increased price in fixed rate bonds in times of stress

All prices and yields are a guide only and subject to market availability. The yields and margins quoted assume all bonds in the portfolio run to maturity, however it is possible that some may be called before the maturity date which would impact the figures slightly. FIIG does not make a market in these securities.

Disclaimer 

The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced, distributed or to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

The information has been prepared solely for informational purposes only and does not constitute or form part of any offer for sale or subscription of, or solicitations or any offer to buy or subscribe for, or any invitation to subscribe for or purchase any securities and nothing contained herein shall form the basis of any contract or commitment whatsoever. The information is being furnished to you solely for your information and may not be reproduced or redistributed to any other person. No action has been taken to permit the public distribution of the information in any jurisdiction and the information should not be distributed to any person or entity in any jurisdiction where such distribution would be contrary to applicable law.

The information has not been lodged with Australian Securities and Investments Commission or any other authority. The information is intended for distribution only to financial institutions and professional investors whose ordinary business includes the buying or selling of securities in circumstances where disclosure is not required under Chapter 6D.2 or Chapter 7 of the Corporations Act 2001 of Australia (the “Corporations Act”) and only in such other circumstances as may be permitted by applicable law. Any securities that may be offered by the Issuer in, or into, Australia are offered only as an offer that would not require disclosure to investors under Part 6D.2 or 7.9 of the Corporations Act. This information is directed only to persons to whom disclosure is not required under Part 6D.2 or 7.9 of the Corporations Act. The information is a summary only and does not purport to be complete. It does not amount to an express or implied recommendation or a statement of opinion (or a report or either of those things) with respect to any investment in the Issuer nor does it constitute a financial product or financial advice. The information does not take into account the investment objectives, financial situation or needs of any particular investor. FIIG does not provide accounting, tax or legal advice. Prospective investors are required to make their own independent investigation and appraisal of the business and financial condition of the Issuer and the nature of any securities that may be issued by the Issuer. By accepting receipt of the information the recipient will be deemed to represent that they possess, either individually or through their advisers, sufficient investment expertise to understand the risks involved in any purchase or sale of any financial securities discussed herein.

Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the Issuer which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice. No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

Any offering of any security or other financial instrument that may be related to the subject matter of this communication will be made pursuant to separate and distinct documentation (“Offering Documents”) and in such case the information will be superseded in its entirety by any such Offering Documents in its final form. In addition, because the information is a summary only, it may not contain all material terms and the information in and of itself should not form the basis for any investment decision. Any decision to purchase securities in the context of a proposed offering of securities, if any, should be made solely on the basis of information contained in the Offering Documents published in relation to such an offering.

Neither FIIG nor the Issuer shall have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG or the Issuer be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG has been engaged by the Issuer to arrange the issue and sale of the Notes by the company and will receive fees from the issuer of the Notes. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. FIIG’s AFS Licence does not authorise it to give personal advice. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of FIIG’s staff or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that all of the views expressed in this document accurately reflects their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG.