Tuesday 20 January 2015 by FIIG Securities growinginvestment Education (basics)

Busting the seven key myths about bonds - Part 7

Late last year we covered six keys myths about bonds. This article is the last in the series and discusses why it’s important to hold bonds as well as hybrids as part of your fixed income allocation.

Myth #7 I own hybrids so I already have an allocation to fixed income

Reality #7 Hybrids have traditionally been part debt and part equity. But recent bank issues have become much more like equity, so do not provide the same level of protection in a downturn.

That’s why it’s important to own a range of fixed income investments including low risk bonds that have more stable prices in a distressed market compared to hybrids.

Hybrids can miss paying interest and can have long terms until maturity

Hybrid distributions can be missed and in the case of many hybrids forgone and never paid to you, making investment in hybrids higher risk than deposits and bonds.

Also, most bank hybrids are perpetual, meaning there is no defined maturity date. A requirement of bank and insurance regulators, such as APRA, is that these securities must be perpetual and have non-cumulative coupons (i.e. the coupon payments can be forgone without penalty) in order to qualify as capital for the all important capital ratios of these entities. Many corporate hybrids also have very long terms until final maturity. Some are out to 60 years, which means you have to sell the hybrid to get your capital back, if it is not called early at the sole discretion of the issuer.

Hybrids typically contain clauses with call or conversion dates before final maturity but there are usually conditions attached and the dates are by no means guaranteed with the power in the hands of the issuer.

On the other hand, bonds and deposits have known interest payment and maturity dates, which if not met are an event of default.

Hybrids have all of the downside risk of equities, without the upside. Bonds offer neither downside, nor upside, just greater certainty you’ll be paid your interest and principal

Our research shows that hybrids are much more volatile in price than bonds and are more likely to track the underlying share when markets are distressed as the graph below comparing three Commonwealth bank investments demonstrates.

The purpose of the graph is to show a worst case scenario and the volatility the various investments showed during the crisis.

We invest $100 on the 29 December 2007 and then track performance throughout the global financial crisis. The red line shows the value of major bank senior bonds, the green, the Perls III hybrid and blue, the CBA shares. The returns shown include interest payments on bonds, distributions on the hybrids and dividend payments on shares, as well as franking credits.

CBA investments in the capital structure

The senior bond line shows a fairly gradual upward trend increasing in value. The GFC does not impact its value, enabling investors to sell if needed and recoup their capital. The returns are stable and consistent, in fact boring, but in bond investment we think “boring is good” as it is what protects your portfolio. In this example the senior bond line is a composite of the “Big 4” banks and not just the CBA given that senior bank bonds generally are only issued for five years and the graph is over a longer period.

The hybrid, being higher risk than the bond, shows increasing volatility. In the worst case scenario, an investor selling in March 2009, would have lost approximately 30% of their capital. The hybrid recovers somewhat, but does not catch the lower risk bond in terms of return.

The shares show the most volatility as they are considered highest risk, falling over 50%. But, notice how the hybrid declines like the share and loses 30% of its value. If your fixed income allocation is 100% hybrids, we think you are taking on too much risk in your portfolio and not providing enough of a hedge against your shares.

I think of CBA as being the lowest risk company on the ASX. The other major banks are also low risk but if you only own bank hybrids, we’d expect all of them to perform in a similar fashion under stressed market conditions.

In fact if you own the new style hybrids with conversion clauses to shares, they are likely to be more volatile than the old style Perls III shown in the graph.

Managers of large investment funds know the best way to combat uncertainty and to protect capital and income is to diversify investments. Replacing some of your hybrids with lower risk bonds will help to lower the risk and improve diversification in your portfolio.

Other articles in this series include…
Myth #1 My portfolio consists of shares and cash and I don’t need a bond exposure
Myth #2 It’s a bad idea to invest in bonds when interest rates or inflation are rising
Myth #3 Bonds are too risky
Myth #4 Fixed Income returns are low and will be a drag on my portfolio’s performance
Myth #5 You need a lot of money to buy bonds directly so go for a managed fund instead
Myth #6 There is too long to wait until maturity