Tuesday 24 July 2018 by FIIG Securities carrace Opinion

How to beat the banks with a corporate bond portfolio

As published in The Australian on 21 July 2018

Bank shares have been a favourite long term investment for reasonably consistent income. But it's time to consider the real income providers - corporate bonds, some of which earn equity like returns of six per cent per annum plus

Bank shares have been the staple of share portfolios for such a long time that we’ve grown emotionally attached. I’ve met investors whose parents worked at a bank and built portfolios over many years of service. Just as a good party must end, so should a share investment with negligible growth prospects.

To sell an old favourite is understandably difficult, as bank shares have delivered over time. But a recent comment by Melinda Cilento, chief executive of CEDA (Committee for Economic Development Australia) in relation to the Banking Royal Commission, resonated in regards to future growth expectations, “If you have a bank growing profits at 12 per cent per annum when nominal GDP is four percent or below in a mature market, shouldn’t someone be asking what’s going on there?”

Inherently we know the banks cannot keep reproducing historical double digit returns and the Banking Royal Commission might hasten more sustainable, lower, longer term growth rates.

Major bank shares have often been sought after for income, sometimes being referred to as bond proxies. But the two assets are fundamentally different - remember the mantra ‘shares for growth, bonds for income’.

So, it’s time to move on from the proxies and think about investing in the real bonds that are reliable income providers and also capital stable. You can rely on the income and expect to be repaid the $100 face value of the bond at maturity as bonds are legal obligations.

There is a huge range of bonds available. Lowest risk government bonds pay around 2 per cent per annum, with other bonds increasing in risk and return to 10 per cent per annum and even higher.

I would generally say a low risk, investment grade portfolio would earn 1 to 2 per cent per annum more than deposits throughout the economic cycle, so 3.7 to 4.7 per cent per annum.

Selling down bank shares and investing in corporate bonds, you have many options to increase diversity. Bonds are issued by Australian companies not listed on the ASX, some big international companies issue Australian dollar denominated bonds, while investors can also access foreign currency bonds.

It would be difficult for income from a bond portfolio to beat bank dividends if the banks maintain current yields of circa 6 per cent and assuming you can claim franking, total income would be around 8.5 per cent. But returns on bank shares are not just about the dividends.

Last year’s ASX Russell Investment Long Term Investing report found that Australian bonds had outperformed Australian shares over the prior decade.

Long term returns
Annualised 10 years to Dec 2017

Source: Russell

Shares are higher risk investments than bonds in the same company. The certainty bonds provide comes at a cost, generally lower overall yields.  Income on shares is not guaranteed. Indeed, perhaps some of the banks will decide to cut dividends in the upcoming results season. Further, investors have to decide to sell to recoup capital, so ultimately returns are not known until the shares are sold.

It is possible to try and match bank dividend yields with a bond portfolio and there are certainly corporate bond portfolios earning 6 per cent per annum.

Remembering that the bond market is generally a lower risk market, to achieve 6 per cent per annum returns you would need to accept higher risk positions.

Some of the bonds that yield over 6 per cent per annum available to retail investors include: Australian dollar issuers – high end property group Sunland, maturing in November 2020 with a yield to maturity of 6.43 per cent per annum, Axssesstoday, a commercial equipment finance provider, has two bonds - a fixed and a floating rate maturing in 2020 with a yield to maturity of 6.11 and 7.07 per cent respectively. Finally, StockCo Holdings, a niche provider of specialty agricultural finance which has a bond maturing in October 2021 with a yield to maturity of 6.59 per cent.

If you can qualify as a wholesale investor, there are many more opportunities, including investing in the US high yield market. For example Newcastle Coal Investment Group’s USD bonds expected to mature in March 2027 paying a yield to maturity of 8.17 per cent per annum, while fellow Australian underground mining contractor, Barminco also has a high yield USD bond maturing in June 2022 with a yield to maturity of 7.71 per cent. These are unhedged positions, so investors also take on currency risk.