Wednesday 01 December 2021 by Jonathan Sheridan Bond-basics-3 Education (basics),Education

Bond Basics #3

In the last two editions we have covered the essentials of the background to owning bonds and why we think Australian investors should own more (here), and the basic information about bonds and the way they work (here).

In this final edition for the Bond basics series we will explain the capital structure – one of the key defining pieces of information about the risk of your bond – and see how it works in practice.

We will also look at some examples of the risk/return trade-off of various different portfolios.

Capital Structure

The capital structure determines the order of repayment of the liabilities of an issuer should that issuer go into liquidation. This happens very rarely but can make a lot of difference depending on who the issuer is!

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Most issuers do not have bonds issued from all parts of the structure, so it can sometimes be challenging to determine what the impact of the different levels has on the risk and return of the particular bond.

Thankfully the large banks issue securities from all points of the capital structure and their price action can be easily tracked. The below shows the price movements of four securities issued by CBA through the COVID crisis (indexed to 100 at 2/12/2019):

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It shows very clearly the extra volatility of the lower ranked securities, notably the equity and the hybrid (who’s future valuation is less certain) compared to the subordinated and senior debt, who have a much lower risk.

This clearly demonstrates how higher ranked bonds can dampen portfolio volatility through periods of market volatility and improve the risk/reward balance of portfolios.

Risk and return balance

Portfolios can be constructed to deliver different, and bespoke, risk and return outcomes. Typically, these deal with the basic risks associated with bond portfolios, namely credit and interest rate risk, and the way these can be manipulated to achieve a certain return.

Typically taking more of either risk will result in a higher yield, and so when constructing portfolios, we try to identify bonds who have a yield that in our opinion is not reflective of the risk (i.e. higher yield than the risk justifies) and therefore offer value to investors.

Sample portfolios

FIIG runs three sample portfolios with lower to higher levels of risk, and commensurate returns.

We will look at the lowest and highest risk/return combination as detailed below. The Sample Portfolios can be found here.

Conservative portfolio

This portfolio is all investment grade and all AUD.

The current portfolio yields 3.52% and consists of 10 bonds of roughly equal weight by value to total an approximate $500k spend.

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High Yield portfolio

The High Yield portfolio looks to generate a high yield while still looking to have a bias towards as low risk positions as possible.

This is achieved by good diversification and attempting to identify fundamentally mispriced bonds.

The current portfolio has 16 bonds, yields 6.59% and is an approximate $500k spend, demonstrating the concept of greater diversity in higher risk positions.

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Should you have any questions about any of the topics raised in our Bond Basics series or the Sample Portfolios, please get in touch with your FIIG representative.