Tuesday 19 July 2016 by FIIG Securities FIIG Securities Opinion

A bond portfolio to beat the biggest

As published in The Australian on 19 July 2016

Ian Silk, Chief Executive of the $100 billion AustralianSuper fund, has dispelled any doubt that we are stuck in a low interest, low inflation environment, announcing this week that AustralianSuper’s Balanced Fund had returned 4.54 percent for the 2015 to 2016 year

Silk added that “Super fund returns are going to be in the mid single digits at best for the next couple of years at least”.

While the return was pleasing, it was also surprising. It’s a huge fund with many asset managers at its disposal. I wondered whether it could have done better when compared to our current bond portfolios which at the moment yield between from 4.5 percent to 6 percent? 

Further, a high 75 percent of investors are in the balanced fund and Silk’s comments imply returns will be similar in coming years.

One of the issues may have been the fund’s over reliance on equities. According to data compiled by Bloomberg, local shares returned 4.9 percent for the 10 years until 30 June 2016, while Australian corporate bonds achieved 6.7 percent a year return.

It got me thinking that I could construct a diversified retail bond portfolio – accessible to all investors – that could beat the 4.54 percent return with a high degree of certainty.

Nothing like a challenge!

Company Sector Maturity/call date Bond type Yield to maturity Capital price Face value Capital value 
360 Capital Property 19/09/2019 Fixed 6.09% 102.300 $50,000 $51,150
Adani Abbot Point Terminal  Infrastructure 29/05/2020 Fixed 8.41% 95.750 $50,000 $47,875
Downer Group Finance Other corporate 29/11/2018 Fixed 3.44% 105.194 $50,000 $52,597
JEM (Southbank)  Infrastructure 28/06/2018 Fixed 3.75% 105.365 $50,000
Qantas Other corporate 19/05/2022 Fixed 4.21% 118.143 $50,000
Stockland Trust Property 25/11/2020 Fixed 3.12% 120.737 $50,000
Praeco Infrastructure 28/07/2020 Fixed  4.10% 111.200 $50,000
G8 Education Other corporate 03/03/2018 Floating 5.92% 99.650 $50,000
SCT Logistics Infrastructure 24/06/2019 Floating 5.94% 100.600 $50,000
Sydney Airport Infrastructure 20/11/2030 Inflation linked 5.73% 125.558 $50,880 $50,223
 Total   $500,880  $529,693

Source: FIIG Securities
Note: Bonds are available to all investors
Minimum investment per bond $10,000, up front $50,000
Prices accurate as at 14 July 2016 but subject to change
Inflation linked bond assumes inflation of 2.5%, the RBA target mid point

While I know the amount invested per person varies greatly in superannuation, I’m going to assume a $500,000 portfolio to show what’s possible, and invest in ten bonds worth approximately $50,000 each.

Corporate bonds are a defensive, low risk asset class. So while I only have ten investments there is a good range of diversity within the portfolio and as the asset class is low risk, I’m not as concerned with a greater allocation per investment as I might be in a higher risk asset class.

The main features of the portfolio are:

  • Capital outlay for the portfolio is $529,693 based on a face value of $500,880. Generally, bonds are issued at $100 face value and this is the amount repaid to investors at maturity. Once issued, bonds begin to trade and can trade at more or less than face value. Declining interest rates and high demand for bonds means eight bonds are trading at more than $100, increasing the initial outlay.
  • One of the important considerations is ‘yield to maturity’. This shows the overall return if the bonds are held until they mature. The overall projected yield to maturity for all ten bonds is 5 percent per annum.
  • Cash flow income for the next 12 months is $32,708, equivalent to just over 6 percent of the capital value of the portfolio. No matter what happens to the price of corporate bonds during their life, if investors hold to maturity they will have a positive return.
  • The main source of income for a bond broker is the brokerage, that is the difference between the buy and sell price of the bond, and this is already incorporated in the prices shown. The only other charge is a custodial account fee and on a portfolio this size it is 0.14 percent per annum.
  • Seven of the ten bonds are rated by the credit ratings agencies as investment grade – Adani Abbott Point, Downer, Southbank TAFE, Qantas, Stockland, Sydney Airport and Praeco, a public private partnership where funds were used to build defence buildings in Canberra. Of the three high yield bonds, two are ASX listed; property company, 360 Capital and G8 Education, a childcare provider. The other, SCT is a logistics company with significant long term contracts.
  • Five bonds are classified as infrastructure, providing difficult to replicate, long term assets, perfect for investors looking for stability of income and capital preservation in retirement, while seven bonds are fixed rate.

These bonds provide absolute certainty of income and as this is critical in retirement, also practical. Two bonds, G8 Education and SCT are floating rate, so income goes up and down over the life of the bond and are protective if the market thinks interest rates will rise, as bond income will also rise.

One bond is inflation linked. Inflation is fairly benign but is often referenced in target returns in SMSF deeds. The Sydney Airport bond I’ve included is long dated, maturing in 2030. Part of its income is derived through inflation while income is fixed at 3.16% per annum, which also grows with inflation.

This is just a sample portfolio and not a recommendation. It’s meant to show that SMSFs can invest for themselves and earn market returns.

There are a broad range of bonds with varying risks and returns available. The beauty of direct investment is that you get to choose the companies you want to invest in, when to buy and sell and income is paid directly to your account.

One final point; fees become proportionally more relevant as interest rates fall. Those choosing to invest in bonds through funds gain diversity but lose control and in a low rate environment it is much harder to beat a benchmark if fees are relatively high.