Tuesday 22 May 2018 by FIIG Securities defencekick Opinion,General,At FIIG

Move to investment grade and give your portfolio an upgrade

Portfolio diversification is an art, not a science. Here are a mix of investment grade AUD and high yield USD bond suggestions to warrant a more defensive portfolio

I was reminded by Michael Cooper’s article in The Wire of being ‘match fit’ or in fixed income terms, of having your portfolio deliver the right outcome.

The article reinforces our want of stability of income and returns from our bond portfolios, with some of us prepared to have a smaller allocation to higher risk product in order to generate alpha, where alpha represents excess returns, and beta represents market returns.

This helps us frame our portfolios in understanding how much allocation we want to investment grade bonds, typically made up of at least 60% investment grade, according to Cooper, and a diversified holding of other bonds for the remainder.

The key is the diversification as ‘default correlation’, which in my opinion is an art, not a science, and it’s often not clear whether it’s a positive or negative when a company defaults. Just think of General Motors – if it were to disappear, is that likely to be a positive for Ford as they have lost a major competitor, or does it tell us that structurally the industry has changed forever.

I’d like to reinforce the Cooper article and say that if we foresee tougher times ahead, or the cycle is ending, then a more defensive portfolio with a higher allocation to investment grade product is warranted. This is especially in defensive sectors like infrastructure where FIIG Research have an Outperform and they are also positive on the financial sector too.

Names to consider in the investment grade space include IAG, Adani Abbot, Asciano, DBS, Praeco and Sydney Airports.

Company Maturity date Type Coupon rate  Yield to worst*  Minimum investment amount 
IAG 15-June-24c Floating rate BBSW+2.10% 4.36%pa AUD10,000
Adani Abbot Point Terminal 29-May-20 Fixed rate 7.10% 4.65%pa AUD10,000
Asciano 12-May-27 Floating rate BBSW+2.60% 4.69%pa AUD10,000
19-May-25 Fixed 5.25%  4.36%pa AUD10,000 
12-May-27 Fixed 5.4%  4.62%pa AUD10,000
DBS 16-Mar-23c Floating rate BBSW+1.58% 3.84%pa AUD10,000
Praeco 28-Jul-20c Fixed 7.13% 4.07%pa AUD10,000
Sydney Airport
20-Nov-20 Inflation Linked  3.76% CPI+2.19%pa AUD10,000
Sydney Airport
20-Nov-30 Inflation linked  3.12% CPI+2.84%pa AUD10,000

Source: FIIG Securities
*Note yield to worst is accurate as of 22 May 2018, subject to change

I understand it’s not easy for any of us to switch out of bonds and accept a negative internal rate of return (IRR). However, if clients are holding bonds that we no longer like, notably in USD, then we must ensure they are fully aware of the risks. Hopefully a lower exchange rate below 0.7500USD rate will help generate positive IRR’s for clients who measure returns in AUD.

Bringing funds back home

Cooper suggested one of his main themes was switching from US high yield into investment grade AUD. We’re not saying to completely exit US high yield, rather review, understand the risks and make sure you are happy holding the bonds.

For those clients who don’t wish to switch from high yield US dollars to investment grade AUD, consider moving up the credit curve to higher rated high yield bonds or into high yield names that currently offer better prospects and good relative value, including those covered by FIIG Research.

Specifically, we recommend better buys in NCIG, Ausdrill, Virgin’s 2019 and 2021 bonds, Bristow and Barminco; and exit those we have concerns with, specifically Talen, the Noble 2024 bond and Ensco.

Company Maturity date Type Coupon rate  Yield to worst*  Minimum investment amount 
NCIG 31-Mar-27c Fixed 12.5% 8.19%pa USD100,000
Ausdrill 1-Nov-19 Fixed 6.875% 5.95%pa USD200,000
Virgin Australia 15-Nov-19 Fixed 8.5%  6.02%pa USD10,000
Bristow 1-Mar-23 Fixed 8.75%  7.49%pa  USD10,000 
Barminco 15-May-22 Fixed  6.625% 7.23%pa  USD10,000

 Source: FIIG Securities
*Note yield to worst is accurate as of 22 May 2018, subject to change