Returns on investment grade bonds are low. Allocating a portion of your portfolio to sub investment grade and foreign currency bonds will help improve the yield. We show our Income Generator Portfolio and a mini USD HY portfolio
Over the years we’ve presented a range of sample portfolios to show what is available.
Our Income Generator portfolio was developed by our Portfolio Strategy and Research teams to show an example portfolio and the associated yields on offer. We use a mix of investment grade and sub investment grade bonds in Australian dollars, and we also have an allocation to foreign currency bonds, normally in US dollars. Please see a glossary at the end of the note for an explanation of some of the terms.
Like our All Australian Investment Grade portfolio all three types of bonds - fixed, floating and inflation linked, have an allocation, in line with the Portfolio Strategy (PSS) recommendation. Currently, PSS suggest that investors allocate roughly equal percentages to the three different types of bonds – fixed, floating and inflation linked securities. Typically, the allocation to floating rate and inflation bonds is achieved in Australian dollars as almost all the foreign currency bonds we transact are fixed rate.
Sample US Income Generator portfolio
Source: FIIG Securities
Figure 1
Note: The portfolio shows projected income and has weighted average calculated attributes in the top right hand corner. To project returns and cashflows for these bonds, we use a 2.5%pa CPI rate, which is the RBA target mid point for inflation.
Source: FIIG Securities
Figure 2
The purchase yield or yield to maturity (YTM) is 5.68%pa which we believe offers an attractive return over and above the All Australian Investment Grade portfolio, which currently offers circa 4.45%pa. The current portfolio has 22 names with varying allocations across the issuers.
A significant 70% of the portfolio is still allocated to investment grade bonds, with lower risk and lower yields. Even higher returns are available if you are prepared to take on higher risk. For example, the high yield USD bonds used in the portfolio, as a mini portfolio of circa $220,000 have a 7.86%pa YTM, more than 2%pa higher than the overall Income Generator portfolio.
We have also included a circa 15% allocation to residential mortgage backed securities, supporting our general suggestion to add floating rate, investment grade securities at this point in the economic cycle. These bonds help diversify the portfolio further, although they cannot fully offset the risk from the high yield allocation.
Getting back to the whole portfolio, you can see it has an overweight allocation to infrastructure bonds. Although we practise sector diversification, we are typically comfortable with larger allocations to infrastructure as it exhibits low volatility. Part of the portfolio includes a significant allocation to the securities issued by NCIG Holdings Pty Limited (NCIGH).
These notes require a minimum USD100,000 holding at a cost of approx. USD129,000. This is a large allocation at 15.5% of the portfolio, and in our opinion any security with a 10% or greater allocation needs to have a firm conviction by an investor. This NCIGH security has an Outperform recommendation from FIIG Research with a Stable credit outlook, supporting our conviction and higher allocation.
In general terms, for a portfolio including sub investment grade and foreign currency bonds, we seek at least 15 bonds in smaller portfolios and 20 in larger portfolios. This is to reduce concentration risk in terms of limiting exposure to any one particular name, noting that sub investment grade and foreign currency bonds are higher risk.
We believe inflation remains a real risk for investors and thus allocate 31% of the portfolio to inflation linked bonds.
If you would like more information on a particular issuer, ask your relationship manager or click on the link - http://thewire.fiig.com.au/bond-issuers
You may also want to look at our e-book How to Build a Portfolio which gives an overview on portfolio construction.
For more information, please call your local dealer or the Portfolio Strategy Team on 1800 01 01 81. The sample portfolio – is now available on the FIIG website. Credit ratings can only be disclosed to wholesale investors.
Glossary
Coupon
The rate of interest paid on a fixed income investment or bond. Coupons can be paid annually, semi-annually or quarterly or as agreed in the terms of the security.
The coupon rate can be fixed or floating for the term of the security. If it is a floating rate then it is likely that it will be linked to a benchmark such as the 90 day bank bill rate. The coupon rate is set by the issuer based on a number of factors including prevailing market interest rates and its credit rating.
Yield to maturity
The return an investor will receive if they buy a bond and hold the bond to maturity. It refers to the interest or dividends received from a security and are usually expressed annually or semi-annually as a percentage based on the investment's cost, its current market value or its face value. Bond yields may be quoted either as an absolute rate or as a margin to the interest rate swap rate for the same maturity.
It is a very useful indicator of value because it allows for direct comparison between different types of securities with various maturities and credit risk.
Note that the yield and coupon are different.
Running yield
The interest rate on an investment expressed as a percentage of the capital invested. It takes no account of the capital accumulated. It is used to describe the income investors receive from their portfolio as a percentage of market value of the securities.
Fixed rate bonds
A fixed rate bond is a security that pays a fixed pre-determined distribution or coupon. The coupon of a fixed rate bond will be set at the time of issue and not change during the life of the bond. The Commonwealth Government, state governments, banks and corporates all issue fixed rate bonds in Australia.
Floating rate bond
A floating rate note (FRN) or bond is a security that pays a coupon linked to a variable benchmark.
In Australia, most FRNs pay a coupon set as a margin above the bank bill swap rate (BBSW) which is the market benchmark three month interbank rate. The actual coupon for an interest period will be determined at the start of that period by applying the margin to the three month BBSW rate on the first day of the coupon period. The three month BBSW rate will rise and fall over time based on prevailing interest rates. The margin is fixed and will be set at the time of issue.
Inflation linked bond
A bond whose base payment rises and falls with the Consumer Price Index (CPI).
Consumer Price Index (CPI)
A CPI is a measure of the average change over time in the prices paid by households for a fixed basket of goods and services.
In Australia, the CPI measures the changes in the price of a fixed basket of goods and services, acquired by household consumers who are resident in the eight State/Territory capital cities.
Credit ratings
Is a measure of credit quality assigned to an issuer and also to particular securities by a professional rating agency. Securities are broadly divided into investment grade (those rated above BBB- by S&P and Fitch, or Baa3 by Moody's) and sub investment grade or speculative (everything below). Due to ASIC regulations, credit ratings in Australia can only be disclosed to "wholesale" investors.
Sub investment grade
This means the bond has been assessed as having a higher perceived risk than investment grade bonds and usually a corresponding higher return and identified by a Standard and Poor’s credit rating of BB+ or equivalent, and below.
Investment grade
This means that a ratings agency has assessed the issuers and that the minimum rating is BBB- or equivalent.