SMSF Investing Education & Strategies

What keeps you up at night ?

Fixed Income may be the solution.

by Justin McCarthy
FIIG Securities.

There are plenty of uncertainties that keep investors awake at night - volatile equities, inflation, property crash, rising interest rates, global uncertainly and many more. In the majority of cases there is a fixed income solution that can put your mind at ease. This article looks at a number of the most common concerns and the fixed income solutions that exist.

Volatile equity markets

The single most common concern we hear is “I can’t handle the volatility in the equity market”. Many retirees have expressed their genuine fear of going on holiday for the risk that their savings nest-egg, which is heavily weighted to equities, will halve in value.

 

And it is not only self managed superannuation funds (SMSF) and retirees, many professional investors have remarked at the difficulty of investing in the stock market over recent times where a comment by say a Greek politician on austerity measures can result in the CBA share price falling 5% in a few days, despite there being no direct connection.

 

Fixed income by definition is much lower risk and accordingly less volatile in market price. The other important distinction from equities is that with fixed income you know the “end-game”. Unless the issuer has gone broke, which is a very rare occurrence, the investor will receive the full face value of the investment on the scheduled maturity date, together with regular coupon payments along the way.

 

So even if the price does dip or move around, as a hold to maturity investor which most retirees/SMSFs are, it does not matter as you have locked in your cash flows and maturity value when you first buy the bonds (the extent of certainty is reduced if you buy floating rate notes (FRNs) versus fixed rate bonds).

There is a great deal of choice in the fixed income market and a very safe, diversified and stable portfolio returning around 7% p.a. can easily be achieved.

 

For those looking for higher yields that may replicate their long term equity return hurdles, fixed income can also provide the solution. Something we often write about is the fact that following the GFC there are a number of fixed income options that are providing excess returns by a historical standard. We term this as the ability to achieve equity like returns for debt like risk.

By moving down the capital structure into subordinated debt and Tier 1 bonds, returns of 9% - 11% can be obtained from household names such as NAB and AXA. Whilst volatility in pricing does increase, this is not such a concern for hold to maturity investors. The other factor is call risk but we are very confident that all these Tier 1 bonds will be called at their first maturity date.

 

Rising interest rates

Rising interest rates are another recurring concern that is thrown up by investors. Many basic texts will (incorrectly) say that rising interest rates are bad for all fixed income. This is somewhat true for fixed rate bonds as typically speaking rising interest rates will see a fall in the price of these bonds, however, this simplistic statement ignores the very large universe of FRNs.

As the name implies, FRNs move with changes in base interest rates. The vast majority of FRNs pay a fixed margin above the 90 day BBSW. Typically speaking BBSW follows quite closely the RBA official cash rates and you would expect that if the RBA is raising rates, that BBSW will also be increasing and there should be little change in price of the FRNs as a result of rising rates.

 

Inflation

There has been plenty of press in the last week about inflation following the worse than expected CPI reading. While we could write an entire article on inflation, in fact we have here, the aim of this article is to simply point out some strategies or solutions to common investor fears.

 

Inflation Linked Bonds (ILBs) are the perfect answer for those worried about inflation eating away at their cost of living, and contrary to popular opinion they can also provide very attractive returns. There are many inflation linked options. These include Federal Government and Semi-Government ILBs yielding 1.50% - 2.75% over inflation (or “real”) to CBA and Rabobank yielding close to 4.0% real. In the corporate sector, linkers such as Sydney Airports and Envestra offer returns of around 5.25% - 5.75% real.

 

A detailed explanation of the mechanics of ILBs can be found here but the main thrust is that the value of the bonds and hence coupons moves with inflation. Some analysts are suggesting the carbon tax will see a spike in CPI and for those that are worried about such impacts, ILBs are an effective solution.

 

FRNs can also be used as a rough hedge against inflation. In ordinary circumstances you would expect when inflation is high the RBA will be increasing interest rates to slow the economy. This would have the effect of increasing BBSW, or the reference rate for FRNs. When BBSW increased the cash coupon paid increases and this may follow inflation fairly closely. However, there are also plenty of reasons why inflation and the RBA cash rate and BBSW do not move in step and for the best protection, ILBs are the answer.

 

ILBs and to a lesser extent FRNs are also the solution to the stereotypical view that inflation is bad for bonds. This is generally true for fixed rate bonds but as the discussion above points out, linking cash flows to CPI or BBSW can address this issue.

 

Property crash

Another common fear of investors, particularly the property centric Australian investor, is what will happen if the residential property market crashes. Obviously this would not be good for direct or indirect property investments. Likewise the equities of property related entities would likely suffer. While a property crash would have a material impact on a number of the common debt issuers, particularly banks and property companies, the impact on bonds issued by those companies would be far less than that of the equities. Property and to a lesser extent bank bond prices may fall but in all likelihood the issuer would maintain all coupon payments and repay the full face value at maturity.Remember that as a debt holder all you need is for the issuer to make sufficient money, or more correctly cash flow, to pay coupons and repay the debt at maturity. Whether say CBA makes $6bn or $1bn doesn’t really matter to debt holders in the short to medium term. Debt is typically a contracted payment and unless the scheduled payments are made the issuer can be wound-up. The same cannot be said for equities where dividends can be cut or cancelled altogether.

 

Investors can replicate some of the attributes of property via various fixed income products including bonds, ILBs and even asset backed securities/residential backed securities (ABS/RMBS). Regular income and/or the capital gain aspect can be structured, and whilst the taxation treatment may not be as advantageous, the underlying fundamentals of the investment are much easier explained. Importantly, many property related bonds will pay interest and principal as scheduled even in a declining property market.

 

Better still, for those worried about property prices, a high yielding investment with regular cash flow can be currently be obtained that returns anywhere from 7% to 11% without the downside property value risk.

 

Retirement - enough money to last?

One of the most repeated concerns we hear is from investors approaching or past retirement age and it comes in two forms:

 

- “Have I got enough money to last?”
- “Equities are too volatile. How can I invest to make my money last but still get a good return?”

This worry is technically known as longevity. The good part is we are living longer but the problem is we either need more money to retire or for those already at retirement age, how do we make the money last longer? This may also extend to how inventors can ensure they have assets to leave to their children.

 

Over the very long term, equities should on average outperform most other asset classes. That is why we believe in the rule of thumb that you should invest your age in fixed income with the balance in higher risk assets. So a 30 year old can afford to have up to 70% in equities as over a 35 year period to their retirement that allocation should smooth out many of the bumps.

However, those nearing retirement age or even more pronounced, those in retirement cannot afford the permanent erosion to their capital base if a heavily weighted equity portfolio experiences a sizeable correction. The GFC is the perfect example.

 

So how can investors obtain a relatively strong return and still achieve that capital stability or preservation? No prizes for guessing - fixed income. As discussed above the range of options is large and in particular the ability to earn equity like returns for debt like risk in the present market. And even if the investments fall in value the cash flows (both coupons and principal payments) are essentially locked in.

 

An extension of this solution for those in pension pay down phase, especially within a SMSF, is to structure a portfolio of bonds and fixed income products with various maturities that can provide an annuity style cash flow tailored for your situation, but still with a relatively high return. This can provide the income, cash flow and flexibility but all with capital preservation in a manner that can address with far more certainty the longevity issues and inheritance planning.

 

Rising A$

The rising A$ is not so much of an immediate concern to most local investors but it does pose a question on the value of some of our domestic assets such as bonds, property and stocks from an international relative value comparison. That is, by international standards, many of our assets appear overvalued.

 

Some investors are looking for opportunities to use the strength of the A$ to buy cheaper assets in foreign currencies. Equities and property can be bought in overseas markets and this does provide an opportunity to take a currency “position”, however the market price and liquidity risks can be severe if investors wanted to exit in a rapid fashion, if for example the A$ fell to say US$0.95 in a very rapid fashion.

 

A rarely used investment option by Australian investors is to purchase foreign currency bonds in parcels as small as $100,000. Buying say a CBA or Westpac senior bond in US$ or € is a relatively straight forward process. Typically speaking the spread or credit margin of an Australian corporate or bank bond is higher in the foreign markets than it is in its local market, in part due to less familiarity with the name.

 

Those looking for a “currency play” can invest in a relatively liquid senior bank bond that is likely to remain very stable in price, pay a reasonable running yield and if/when the currency falls, the senior bond can be sold as the market is typically quite liquid as opposed to property where entry and exit is difficult. A similar process can be conducted with equities but the volatility of the underlying equity price is significantly higher.

 

Offshore uncertainty – US debt ceiling and AAA rating, European sovereign debt concerns

Much has been written over recent days and months about the various issues that have engulfed the US and European markets. While these issues are physically miles away, they have significant impacts on the psyche of Australian investors. However, the fundamental impact on many bond issuers is immaterial, particularly domestic companies and financial institutions that have minimal dealings with the US and Europe. Nevertheless, negative sentiment and lower liquidity has seen significantly reduced entry prices (or alternatively wider credit spreads).

 

Whether or not the USA’s credit rating is downgraded has very little or no impact on say Woolworth’s business and profitability. Whilst financial institutions do have a greater exposure via global funding markets, it is unlikely CBA will see a material change in the way they do business or their profit if Greece ultimately defaults. However, their bonds would most likely fall in price.

 

Any technical weakness (i.e. excess supply over demand, changes to risk appetite, etc) which has very little impact on the fundamental credit quality should be seen as a buying opportunity, and this is our view of the current environment where plenty of “bargains” exist. While it is possible they could be even bigger “bargains” in a few weeks time, from a hold to maturity perspective they are a cheap entry point and there is little to suggest any impact on many domestic (and select international) companies’ ability to pay coupons and repay the principal at maturity or first call date.

 

As discussed above, the “end game” of bonds is known. However, equities can also be picked up cheaply but there is no guarantee as to when or if they will recover in price. Further the dividend payments can be reduced or even cut completely in stressed scenarios. Finally, the technical impacts of off shore developments can have long term impacts on the equity market. The Australian equities market still has a significant correlation to the US stock market despite the relatively small trade conducted between the US and Australia and many events that have no direct bearing on the fundamentals and profitability of our domestic companies. Bonds will always have that “pull to par” as they approach maturity date.

 

Justin McCarthy
Director, Financial Institutions and Corporate Research - FIIG Securities.

 

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