Wednesday 23 January 2013 by FIIG Securities FIIG Securities Legacy

The darling of the bond market

Telstra was the darling of the stock market in 2012 returning around 40% for those investors who picked the stock at the beginning of the year, beating considerably the ASX 200 Accumulation Index (reinvests the entire dividend) which rose 18.95% over the year

Now most of you will be generally aware that the fixed income market also had a good year and the benchmark index, the UBS Composite Bond Index appreciated by 7.70% over the same period. But, can any of you guess the darling of the bond market?

Gold star if you guessed AXA SA. The AUD fixed rate hybrid Tier 1s returned 39.6% for the 12 months until 31 December 2012 based on a 29.8% capital appreciation and 9.74% income; a great performance. Now, if you had similarly structured AXA SA hybrids in foreign currencies (still available to Australian investors) you would have done even better. The AXA SA USD 2018 hybrids returned a massive 58.2% for the year and the EUR put in a not bad performance of 55.5%. Who said bonds were boring!

Figure 1

Before I go onto discuss other star performers in the over-the-counter bond market, let’s have a look at some sample returns from other sources of fixed income.

Like any market, performance is often gauged on a benchmark. I think it’s worth assessing the fixed income benchmarks first to put returns in perspective. Most often in Australia the benchmark is UBS Composite Bond Index, which measures returns from around 300 bond issues. This index is heavily weighted to government bonds as the government and the states and territories are the largest issuers in Australia, although it does have about a 30% weighting to low risk corporate issuers. Given the very low risk nature of the Index the return of 7.70% is very good (over two years the total return was 9.52% and five years 8.26%). The other benchmark we could consider is the UBS Credit Index, which returned 9.83% in 2012.

If you are comparing these to the ASX 200 Accumulation Index, you need to remember that shares are much higher risk, so should provide much higher returns, but as an investor you would expect greater volatility. In fact the ASX 200 Accumulation Index while outperforming the Composite Bond index this year was down 9.51% in 2011. See Figure 1 below comparing the UBS Composite Bond Index and the ASX 200 Accumulation Index.


Figure 2

Notice how the Composite Bond Index generally rises throughout the last 12 months, yet the ASX 200 Index is more volatile. The indices really show why you need a diversified portfolio, the consistency of a fixed income investment reduces volatility and helps protect income and capital.

Making the assumption that you all appreciate the need to add fixed income to your portfolio, let’s assess how the different avenues performed against the benchmark of the UBS Composite Bond Index.

Table 1 shows returns of ETFs issued earlier this year. It’s worth noting that returns are not annualised and would be higher given these funds did not list until March or April. All the funds appreciated in capital value, which in most cases made the greatest contribution to return. The iShares Government inflation and the Russell Government bond appreciated the most, yet the interest earned was lowest on these securities.

Source: FIIG Securities, Company websites

Table 1

Managed fund returns (from our sample) were generally slightly better than ETFs (see Table 2) but capital appreciation was lower (a function of the out-performance of government bonds) and interest income was higher. All except the Aberdeen Australian Fixed Income Fund beat the UBS Composite Bond Index (see Table 2 below). Returns close to 10% for relatively low risk investment, when compared to the equity market are excellent.

Source: FIIG Securities, Bloomberg

Table 2

The ASX listed market was very much a mixed bag. Five of the eight securities in our sample actually depreciated in capital value over the 12 months; the highest being the AMP Group Finance Services Ltd (AQNHA) by 3.70% and after interest earned of 8.15%, total return was just 4.50%. The return is lower than the UBS benchmark of 7.70%, and lower than the lower risk ETF and managed fund investments, given their diversification (see Table 3). The ANZPC, the IANG and the WBCPB all returned less than the benchmark.

The two most attractive investments from our sample were the Transpacific SPS Trusts (TPAPA) and the Heritage Notes (HBSHA) returning 31% and 11.5% respectively. The TPAPAs appreciated in price from a low base and were still trading at a substantial discount at year-end of $88.47, which means the market considers the securities high risk. The Heritage subordinated, fixed rate bond was a great investment given a fixed 10% coupon (interest payment) and it’s no surprise it was trading at a nice premium of $111.50 at year end. These two securities go some way to highlight the differences in risk of the retail ASX listed securities. The poor performance of the ANZ and Westpac securities were a bit of a surprise, perhaps investors were selling the hybrids to buy the shares.

Source: ASX

Table 3

*Maturity or first call date

In the over-the-counter (OTC) market (where investors need to find a fixed income broker to trade) which is generally the preference of more sophisticated investors, multiple sectors outperformed. Discounted hybrids, long dated bonds and discounted European names rallied hard and meant many investors made double digit returns for the year. Table 3 shows the top performing AUD bonds; all seven achieving returns greater than 20%. There were others that returned over 10% but there were too many to list. These returns help explain why we think selectively choosing individual bonds and making up your own portfolio is better than following an index or buying into a managed fund. Owing ten or so of the best bonds can achieve superior returns than owning a diversified index.

Investors who are active with their portfolio and want better returns can achieve better than industry standard benchmarks.

Source: FIIG Securities

Table 4

*Maturity or first call date

Foreign currency bonds were the stand-out performers in the OTC market in 2012. Top of the tree were the AXA SA hybrids as investors sought risk-on trades after ECB President Mario Draghi’s famous “whatever it takes” comment. Returns were very high especially given the very low deposit rates on offer in European countries (not taking into account currency movements). The best performing Australian name was the Macquarie bank EUR fixed subordinated debt. These bonds returned 48.3%; 40.6% from capital appreciation and 7.74% from income (see Table 5).

Source: FIIG Securities

Table 5

*Maturity or first call date

Other great performances from Australian names included: NAB Capital Trust EUR hybrids returning 41.0%, ANZ Capital Trust EUR hybrids with 27.1% and Suncorp Insurance GBP subordinated debt with 25.7%. The discount offered on these securities at the start of the year and the corresponding high returns left the retail ASX listed securities looking too expensive by comparison.

Telstra performed well last year but so did many of the lower risk bonds available in the OTC market.

While many market commentators feel the market has turned and it’s now time to embrace a risk-on strategy, I think it’s important to remember that the world’s problems are not fixed; there are still a lot of countries with very high debt levels with no easy way out. Confidence may be improving but tough fundamentals remain.

Australian companies are hurting, as evidenced in the last few days by Boral and QBE committing to cutting costs through redundancies. This will flow though to keep consumers cautious. Volatility should remain. Diversification is key, as always, spreading your risk over multiple asset classes and multiple sectors will help protect your portfolio. By all means target some of those risk assets but remember share prices fluctuate (as do bond prices) but at the end of the day if a company remains solvent it will repay the $100 face value of its bonds at maturity but there’s no such guarantee with shares.