In our first article in the series we set the scene and looked at the style and diversification aspects of building a portfolio (here), and the second article dealt with credit and interest rate risk (here).
In the final article of the series, we round out the rest of the risks we typically consider, being which includes liquidity and foreign exchange (FX), as well as look at how to appropriately size the various positions of each bond within the portfolio.
It is important to note that there are other risks – such as geopolitical risk (to the legal system under which the bond is issued), systemic/sectoral risk (risk that affects all issuers in a particular sector) or idiosyncratic risk (that which applies to that particular issuer alone), but we believe these are all rolled up into the credit risk of the issuer, and so we are not examining them individually.
Liquidity risk
Liquidity risk is defined as the risk that you cannot exit your position without materially moving the price.
This takes two forms when considering the positions typically held by our clients:
- The ability to transact in a parcel size >$500k in a normal market
- The ability to exit a position when market wide liquidity dries up, such as in a crisis
Liquidity risk in general is mitigated by bond investors by having a maturity date – a defined future date when repayment of capital is expected. Therefore liquidity, as a hold to maturity investor, is not something that is necessarily overly worrying, as there is no requirement to sell the bond to secure your capital back, as long as you are prepared to wait until maturity.
In equity markets however, where the only way to obtain your capital back is to sell, this liquidity risk is extremely important, and one of the reasons that Warren Buffett is widely quoted on this front:
Bond market liquidity, just like equity market liquidity, declines as you move into smaller sized issues and issuers who require more work to understand.
Therefore, the best liquidity is typically found in government bond markets (or ASX Top 50 stocks), and then next best in semi-government or other non-government AAA rated issuers (Top 100 stocks) and then down the list to individual highly rated (A and above) corporate investment grade issuers (Top 200 stocks) and so on.
Issue size is largely correlated to liquidity, simply because the larger the issue the more participants who are holders and may be willing to trade the bonds.
FX Risk
Overlaying all the other risks we have discussed in these three articles is FX risk.
Clearly this risk can be avoided entirely by not investing in bonds which are denominated in a currency different to your own.
However, for Australian investors, where our bond market is severely underdeveloped compared to a lot of the other sophisticated economies globally, access to other markets, in particular the US market, offers such depth and diversification benefits that in our opinion taking FX risk is worth it for the benefits gained.
So, once the decision is made to invest in bonds in a foreign currency, it is important to note that all of the previously mentioned risks, such as credit, interest rate, liquidity and concentration risk all apply to the individual bond investments.
Additionally, the fluctuations of the exchange rate between the base currency (in our case AUD) and the bond currency (usually USD) add or subtract from the returns made form the individual bond.
Another way to mitigate this risk is to maintain a semi-permanent allocation to the particular foreign currency. This enables transactions to be made within the currency bucket and not worry about either cross-currency transaction costs, or FX moves against you if you are in or out of the currency whilst buying or selling bonds.
At a given time, a decision can then be made to move the entire allocation back to the base currency, typically when the currency is favourable.
Additionally, although we cannot advise on this, basic FX hedging is available to investors through many different means such as contracts for difference (CFDs) or futures.
Position Sizing
Once all of the above factors have been taken into account, the final decision to make is the quantum of each individual position.
Having regard to the considerations and risks discussed so far leads an investor quite easily to a basic understanding of position sizing. Bonds with lower risk can be held as larger portions of the portfolio than those with higher risks, to mitigate the impact of something going wrong in a higher risk position.
Typically, we would suggest a limit of 10% of the portfolio to an investment grade rated bond, and 5% of the portfolio for a sub-investment grade or unrated bond. However, we note this is based on a rule-of-thumb that the portfolio generates 5% income per annum, and therefore the total loss of one high risk position would not impact the total capital position assuming the income was retained.
In a lower interest rate environment this may need to be adjusted for lower allocations to higher risk positions, given the smaller premium available in terms of yield for taking the higher risk.
Conclusion
There are many risks to take into account when constructing a well-designed bond (or other asset class) portfolio. We have covered the main ones in this series of articles which we hope has given you some insight into the way we think when we build our own portfolios.
The sample portfolios which adhere to these principles can be found here, and if you have further questions about these or your own current or future bond portfolio we encourage you to get in touch.