To get the most out of bond investments it is necessary to
review your portfolio periodically. While your FIIG relationship manager can
help you with this at any time, each year a number of FIIG client portfolios
receive a centrally generated, formal Portfolio Scorecard. With those annual scorecards
having recently been sent, it’s timely to talk about how to get the most out of
a portfolio review.
Background
To ensure a bond portfolio
still meets the owner’s investment objectives, it’s important the components of
that portfolio are regularly reviewed. Over time, market conditions change and
so too do the individual investors’ circumstances. Portfolios need to adjust to
reflect both of these changes.
FIIG’s Investment Strategy
Team conducts a yearly Portfolio Review for all FIIG clients with portfolios
holding above $150,000, inclusive, across a minimum of five bonds. This annual
in-depth review is in addition to the ongoing consideration and assessments carried
out by the Relationship Manager across the year.
FIIG’s 2024 Portfolio Review
measures key features of a bond portfolio with an eye on the main sources of
risk to bonds, but for the first time, the review also looks at the expected
returns too. As is often the case in investing, higher returns are usually only
available if an investor is willing to accept higher risk. As such, a “lowest”
risk rating is not necessarily good and nor is a “highest” risk rating
necessarily bad. The key question is whether or not the risk and return
features of your bond portfolio match your desired objectives. The intention is
for FIIG investors to take considered risks and to receive the best return
possible within that risk framework. FIIG is licenced to provide general
financial advice only and as such our reviews do not take into consideration
individual circumstances or risk profile.
The key risk measures in the
report are Concentration, Currency risk, Modified duration, Sector exposure, and
Sub-investment-grade holdings. Please note that the Portfolio Scorecard shows
an individual portfolio’s score, alongside the average score for that measure
from the investors in the FIIG client base with a similar portfolio.
Aligning with market moves and outlook
The Portfolio Review is
conducted at the beginning of each year to ensure it is timely and relevant for
the upcoming year. A portfolio constructed last year may have been perfect at
the time but faces different market conditions and a changed outlook this
year.
There can be missed
opportunities, underperformance, and elevated risk if a fixed income portfolio
isn’t periodically fine-tuned to reflect the change in macro themes and
outlook.
This time last year, the RBA
cash rate was 3.10% and the market was expecting an ongoing pattern of interest
rate rises. As we sit at the start of 2024, the situation couldn’t be more
different. As FIIG research discussed in their recent Macro Outlook for 2024
report, the RBA looks like it may have finished raising rates and the main
unknown for 2024 is when will the rate cuts begin.
The 10-year Australian
Commonwealth Government Bond (ACGB) yield had a very unsettled year in 2023. It
traded as low as 3.18% and as high as 4.95% but actually closed 2023 very
close to where it started.
Source: FIIG Securities, Bloomberg
While periods of higher
yields create opportunities to add longer-dated fixed investment grade bonds at
more attractive entry points (remembering a change in interest rates and bond
prices move in opposite directions), it’s important to review portfolios and
identify overweight positions where valuations will be impacted.
Improving returns
Through reviewing portfolio
construction, the overall return can be improved by adjusting individual
positions and identifying opportunities.
The current market seems to
have calmed a little. The prospects for continued RBA hikes have definitely
faded. However, the main reason the RBA has finished seems to be that the
economic “peak” has passed and the economy is likely to weaken in 2024. A
weakening economy does normally mean lower yields and higher bond prices, but
it also comes with a material increase in credit risk.
The key to improving returns
in 2024 is likely to be taking careful positions in longer-duration bonds while ensuring you are not unintentionally increasing risks in other ways by
becoming over-exposed to a particular name or a particular sector.
Managing risk
A regular portfolio review is
a useful tool for identifying the level of risk (and type of risk) in a
portfolio and adjusting the construction accordingly.
In the Portfolio Scorecard
2024, the first risk measure presented is Concentration risk. This measure
shows the proportion of a portfolio (measured in dollars) that is represented
by the largest 10% of holdings (measured in a number of bond lines). This measure
captures how diversified or concentrated a bond portfolio is overall. A high
score suggests that the overall portfolio is dominated by a small number of
bonds.
Currency risk is the second
measured item, but this only impacts portfolios with foreign exchange
exposure. FIIG clients have access to bonds denominated in Euros, Pounds, and
US dollars, which can carry exchange rate risk.
A portfolio review can help
identify where there is too large an exposure to foreign-denominated bonds and
hence carry a larger currency risk.
Modified duration is a
measure of how long the bonds in the portfolio are. When bonds are long, the
interest rates are effectively locked into the portfolio. But if market
interest rates change, the market price of that bond can change. Since a change
in interest rates affects all the investment between now and maturity, the
longer there is until the maturity of the bond, the more a change in interest
rate will change the price. Simply put, the higher the duration the more
exposure the portfolio has to interest rate changes.
The final risk assessed in
the portfolio scorecard is macroeconomic credit risk. This is spread across two
measures. The first is sector concentration which, like the Concentration
measure mentioned above, seeks to highlight diversification (or the lack of it)
in the portfolio. But diversification isn’t just about owning bonds from
different companies, it is about owning bonds with materially different
exposures. Should there be another financial crisis, owning 10 different bank
bonds would not really be effective diversification, even if it looked like it
on paper. Sector diversification is a form of macro-economic credit risk,
because the events that affect entire sectors tend to be larger and related to
macro-economic events, rather than company management.
Certain sectors are
inherently riskier than others and, importantly, different sectors withstand
economic cycles differently. The Utilities and Infrastructure sectors are
considered non-cyclical and more defensive sectors, whereas real estate and
consumer discretionary are typically less resilient in downturns.
The final measure is
sub-investment-grade holdings. “Investment-grade” here means the credit ratings
assigned by the major international rating agencies (Moody’s/S&P/Fitch).
These companies assign ratings based on the quality of the company with AAA being
the highest and C being the lowest. The companies with ratings above BBB- are
called “Investment-Grade” and generally have very low default risk.
Companies below this
threshold are called “non-investment-grade” or “speculative grade”. These
companies have higher risk and much higher default rates.
As the S&P chart above
shows, the historical probability of default decreases the higher the credit
quality and the shorter the duration. For example, an AAA-rated bond maturing in
four years has a historical 0.24% rate of default compared to a B-rated bond
maturing in 10 years with a 24.95% incidence.
Again, however, risk and
return are intertwined. Unrated and sub-investment-grade bonds can be very
effective ways to help a portfolio achieve a higher level of income. It is the
size of the exposure that is important, and a review of the portfolio’s mix of
investment-grade and sub-investment-grade bonds can help ascertain the level of
credit risk.
Conclusion
It’s beneficial to regularly review
fixed income investments to ensure they still match the intended risk and
return profile of the investor. It is not that high-risk portfolios are
intrinsically bad – these risky portfolios often come with the highest expected
returns. The important point to consider is whether the investment risk profile
matches what the investor wants it to be.
FIIG’s Investment Strategy
Team conducts an annual review of client portfolios, in addition to continual
monitoring of portfolios carried out throughout the year. The Portfolio
Scorecards for 2024 have recently been distributed which makes it a great time
for investors to consider the overall make up of their portfolios.