Continuing our exploration of the Benefits of being a Wholesale Client, our next edition highlights the role US dollar bonds can play in diversified portfolios. Previous articles looked at credit ratings (here), FIIG-originated unrated primary issues (here), and structured credit (here).
Many investors are perhaps familiar with the New York Stock Exchange or the NASDAQ, but in fact, the US bond market is the largest and most liquid market in the world.
As a proportion of total Wholesale investments in our custody, over 15% are allocated towards USD bonds with that % much higher when we exclude clients having no USD exposure at all.
At current exchange rate levels, we are not seeing much if any allocation from AUD to USD, but there are still opportunities to switch USD bonds within the currency.
Diversification
While Australia’s bond market – and more specifically our high yield bond market – is underdeveloped, gaining access to a wider range of bonds through the US market is very beneficial for diversification. Similar to local bonds, these are able to be purchased in 10K minimum parcels (unless stipulated otherwise by the issuer) and offer investors the ability to diversify their portfolio allocations through a greater number of issuers and opportunities available for investment.
The chart below compares the USD BB universe to the AUD High Yield index. It is clear that the sheer number of bonds available in USD compared to the relatively small number in AUD allows High Yield investors in particular a much greater choice of risk and reward options:
Source: Bloomberg
Liquidity
To access liquidity when trading AUD-bonds with external institutional counterparties, the usual requirement to
trade is a parcel size of $500,000 face value. We can break these parcels down
via our DirectBond process for individual investors, but we need a collective
effort to be able to trade with the rest of the market in the minimum face
value size required.
While this provides an additional
layer of liquidity for investors outside of our large internal liquidity pool,
building to the size required to execute can take some time.
This limitation however doesn’t tend
to exist in the much deeper and more liquid USD market, as we are often able to
buy and sell bonds in the overnight time zone with foreign institutions and
banks in $100-200K sizes.
This is not only a liquidity
benefit in being able to transact more frequently with the US bond market, but
we are also able to transact in these smaller parcels through USD bonds in our
time zone – as we trade the majority of our Australian credits that have issued
USD-denominated bonds with Asian counterparties*.
Companies Issuing USD Bonds Only
When investors are exposed to a new asset class and have complete control over the investments in their portfolio, name recognition is one of the key factors for investor’s consideration. When looking for foreign currency exposure and the yields that this market offers, investors tend to find comfort in recognising Australian companies who have chosen to issue USD-denominated bonds to meet their funding requirements rather than US domiciled issuers they are unfamiliar with.
Fortescue Metals, BHP and Newcastle Coal are all very well-known local names who regularly issue USD-denominated bonds. The crucial commodity centric issuers mentioned above are fundamental to Australian GDP but tend to have their financial obligations in USD.
Due to these funding requirements, all three companies only issue USD-denominated bonds rather than tapping the AUD market. These issuers focus on issuance in USD as a natural currency hedge given their revenue is predominantly in USD. Being a Wholesale investor gives access to the US bond market, but also to a larger number of opportunities in Australian companies which investors would otherwise not be able to gain exposure to.
Credit Ratings on USD Bonds
As highlighted in our #2 edition
of this series, Wholesale clients are able to gain access to FIIG-originated
transactions. It was highlighted in this piece that these higher-yielding
transactions are unrated, as the companies looking to issue debt are often
smaller in nature.
Comparatively, with the US bond
market being much a much larger and deeper market, the rating agencies rate
every issuer and issue – which is particularly relevant for Sub-Investment
Grade bonds.
Whereas the Australian market
primarily consists of either Government/Semi-Government, Investment Grade or Non-Rated corporate credits,
through USD bonds we also gain access to a number of positions that sit within
the BB basket (BB+, BB and BB-) as well as the single B basket (B+, B and B-).
This is helpful as we consider higher-yielding opportunities for investors
comfortable in gauging the level of risk, they are comfortable taking to achieve
their return objectives.
It is important to note that we
do not enable investors to purchase bonds that have a rating of CCC+/Caa1 or
lower. When a bond gets downgraded from B- to CCC+ or below, this means that
the issuer is highly reliant on favourable conditions to remain solvent in a
12-to-18-month time horizon and this heightened uncertainty means we believe
the risk is too great and therefore we do not offer these as the risk lies outside
of our parameters.
FX Risk
Clearly, introducing USD-denominated bonds into an AUD-based currency portfolio brings with it foreign
currency risk.
In certain environments, such as
when the AUDUSD rate was trading above parity, this exposure is desired as it
can lead to excess gains over and above those earned from the bond investment
alone. Of course, this can go the other way if the exchange rate moves against
the investor.
Our belief is that the
diversification and liquidity benefits offered by the USD market outweigh the
additional FX risk introduced.
The best way to mitigate this
risk outside of direct hedging is to maintain a semi-permanent allocation to
USD bonds and manage the portfolio within the separate currency. Those
features of depth and liquidity allow for this to be done in smaller parcels
which further enhances the attractiveness of USD-denominated bonds.
At some point in the future when
the currency is to an AUD investor’s advantage then the USD allocation can be
closed at an appropriate rate, but until then rotation within the currency
allocation is generally the preferred method.
*It is important for investors to be aware that, should you wish to purchase US-domiciled bonds, you will not only require a Wholesale certificate but also a
valid W-8BEN/W-8BEN-E form applied to your account which relates to tax withholding.
Should you wish to seek further information on this, we would encourage you to
speak with your accountant.
