Low risk bond portfolio for starters
Guest Post : by Elizabeth Moran
Director – Education and Research, FIIG Securities.
Interest in fixed income is gaining momentum as more and more investors are seeking to define their returns and protect their capital. Those of you at or near retirement need the certainty of knowing that your capital base won’t be eroded by volatile share markets or a downturn in property.
For sure, risk a little to improve overall returns but seek to protect what you’ve already worked hard to build. Fixed income offers investors certainty through:
- Capital repayment at maturity (in most cases)
- A defined income stream
- Diversification
The following portfolio is considered conservative and is suitable for investors willing to move slightly down the capital structure to receive returns higher than offered by term deposits.
The portfolio offers exposure to:
- Fixed rate bonds that provide protection for equity investments in a cyclical downturn. When the economy is in a low growth or contracting phase, share prices move lower and investors seek to lock in returns in fixed income. Fixed rate bond prices typically rise at this point in the cycle, so that increases from bonds can offset losses in the equity market.
- Floating rate notes (FRNs) where the coupon is tied to an underlying benchmark (usually BBSW in Australia), so the coupon moves up and down and reflects changes in interest rate expectations. FRNs usually outperform in a growing economy where interest rates are rising.
What is the minimum amount I need to invest?
You can start to build a fixed income portfolio with a relatively small initial investment. Australian Commonwealth government bonds and some semi-government bonds need as little as $1,000 minimum investment, but the returns are very low. There are some bonds traded through the ASX and there is no minimum investment for these. However the vast majority of bonds only trade in minimum face value parcels of $500,000. In an effort to provide access to individual investors, so they can create their own portfolios, FIIG Securities (FIIG) has broken bonds into smaller parcels. FIIG has over 90 bonds available in parcels of $50,000 or $100,000.
A couple of things to note:
- There is no obligation to buy a whole portfolio when you start investing. You can just buy one or two bonds to start, then add to your portfolio over time.
- You can buy and sell bonds for the minimum purchase amounts. For example if you buy $300,000 of a minimum purchase $50,000 bond, you can opt to sell down that parcel in $50,000 lots. There is no obligation to buy and sell the whole parcel at any one time.
- If you are unsure of how markets are going to perform but you think a bond looks good value, you can buy the minimum amount, then keep buying minimum amounts over time to lock in the return now and capture any future upside. Much the same as you would if you were trading equities.
- Generally the lower risk the security the more liquid it will be, that is you’ll be able to sell it quickly without influencing the price you will receive for the security.
How many bonds do you need for a diversified portfolio?
I’m often asked how many bonds are needed for a diversified portfolio. I think you need between five and 10. The answer really depends on the total value of your portfolio and your goals for your portfolio. My preference is for seven securities, but five can work and if you can access bonds with lower face value parcels, that means investing approximately $250,000. Below is a sample portfolio and some additional bonds wholesale investors might consider.
Table 1 shows a retail portfolio (to find out if you’re considered a retail or a wholesale investor, please click here) with a weighted average yield to maturity of 6.68%, substantially higher than the current best term deposit rates. Four of the securities mentioned are not ASX listed companies, providing diversification for your portfolio. We have a preference for floating rate notes at present which explains why four or the securities are also FRNs. Two of the suggested securities are subsidiaries of larger well-known institutions; National Wealth Management Holdings is a National Australia Bank subsidiary and Vero Insurance a subsidiary of the Suncorp Metway Group. While three of the bonds are senior debt, the National Wealth and Vero bonds are subordinated debt, meaning they sit lower in the capital structure. We’re happy to recommend these securities because we have confidence in the underlying credit quality of the issuers. That way, investors can earn greater returns by moving down the capital structure and taking on a little more risk.
FIIG provides detailed research from a fixed income perspective on all of the bonds listed below.
Table 1
Notes: There is some additional call risk associated with the LT2 (lower Tier 2) bonds, which a FIIG representative can explain to you.
The Yield for Floating Rate Notes is the swap rate to Maturity/Call plus the trading margin.
More options for wholesale investors
Table 2
Notes: There is some additional call risk associated with the LT2 (lower Tier 2) and Tier 1 Capital bonds.
The Yield for Floating Rate Notes is the swap rate to Maturity/Call plus the trading margin.
Table 2 shows some suggested wholesale securities that could be mixed and matched with the above retail portfolio depending on your risk profile. We have included three banks – a senior bond issued by BNP Paribas, a long dated senior Westpac bond that matures in 2020 and a hybrid/Tier 1 Capital security issued by National Australia Bank which we think offers good relative value for the risk involved. We are very comfortable with senior European bank debt and consider the BNP Paribas senior debt as high quality and low risk.
Wholesale investors generally have an access to a wider universe of bonds and higher rates of return, therefore it makes sense to determine whether you satisfy the requirements.
How to transact
- Most bonds are traded over the counter (OTC) that is there is no exchange used for the majority of bonds, which means you’ll need to find a fixed income broker like FIIG Securities who matches buyers and sellers in the market. A limited number of bonds are traded through the ASX and you can use your stockbroker to access these securities. Hybrids are also traded through the ASX however the terms and conditions of these securities vary greatly and can be more “equity-like” than ‘debt-like”, so won’t necessarily offer the same diversification benefits.
- Settlement for OTC traded bonds usually takes place three business days (T + 3) after the day the contract is issued for the transaction.
- Investors are issued with a contract note when the trade is agreed which includes the full details of the security involved.
- No fees are paid on the trade. Brokers take a small margin between the seller offering the security for sale and the buyer purchasing the security. But, no transaction would occur unless both were happy with the transaction, which means the margin is typically small. The actual transaction is the only way the broker makes any money. Unlike managed funds, there are no ongoing fees.
- In most cases investors do not receive a certificate for their holdings. The holdings are held in an electronic register called Austraclear. If investors don’t have an Austraclear account, the securities are held in a custodian account, much like shares are held with a HIN.
- If you want to sell bonds, you would need to contact FIIG and we would then find a buyer in the market.
Conclusion
Securities suggested in this article allow investors to sleep at night. They are low risk and provide reliable income streams and preserve capital. If as an investor you buy and hold the securities to maturity, then you should earn the listed returns. However sale of the securities before maturity may result in a capital gain or loss on sale. The portfolio is suitable for retirees, seeking capital preservation and returns in excess of those offered by term deposits for slightly higher risk.
All prices and yields are accurate as at 13 March 2012. These prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.
Note this article appeared in a recent edition of the WIRE, a weekly fixed income newsletter – CLICK HERE to sign up for free.
