Planners whose thinking on fixed income extends no further than managed funds and government bonds might be doing clients a disservice as other opportunities present themselves. Simon Hoyle reports.
CLICK HERE to view full .pdf version
There has been intense focus in the past 12 months on the bond issues being prepared by governments around the world to fund their respective stimulus packages and help rebuild their economies.
While all that’s been going on, Australian companies have been inexorably and astutely rebuilding their balance sheets, mixing debt and equity raisings in the optimum proportions to maximise the efficiency of funding.
Much has been made of the massive amounts of equity raised by Australian companies in the past few months; but in July and August alone in 2009, Australian companies also issued about $23 billion of corporate bonds. (That compares to about $3.6 billion raised in August 2008.)
So when it comes to assessing the potential range of investments for fixed income portfolios “there’s a couple of things that have changed”, says David Bryant, chief executive of Australian Unity Investments.
“If you go back to 1994, most of the bonds on issue were Federal and State governments, and semi-government [authorities],” he says.
“Up until now, that gradually decreased, partly because of decreasing deficits they have had to fund. “Corporate [securities] now represent more than half the index; non-government [securities] are about 55 per cent of the index.”
Bryant says that if investors do not recognise some of the fundamental differences between government and corporate debt securities, they have a high chance of running into trouble. Specifically, says Bryant, if investors do not recognise the risks associated with corporate debt, there’s a high chance of losing money – and there are plenty of examples in the past two to three years where investors lost sight of risk.
He says the risks associated with debt were simply not being priced properly, and as a result investors got a misleading impression of how much risk they were actually taking. But human nature being what it is, when the market realised this, it went too far the other way.
Even “good” risks were priced at a premium beyond their true worth. “You went from a situation where risk was being priced cheaper and cheaper…to being very expensive,” Bryant says.
“AMP did an issue, for example, that averaged about 7.9 per cent. When official rates were at 3 per cent or 3.5 per cent, that’s a very big premium.”
Jeff Brunton, head of credit markets for AMP Capital, says two key risks associated with all bond issues are credit risk and liquidity risk. The former is the risk that the bond issuer defaults on its repayments; the latter is the risk that you can’t buy or sell the volume of bonds you need to, at the price you need to.
Brunton says both government and corporate bonds exhibit interest rate sensitivity and their capital values are therefore inversely related to what interest rates are doing. In other words, if interest rates fall, then the capital value of an existing bond will generally rise, and vice versa.
And of course, if either type of bond is held to maturity, then investors expect to receive 100 per cent of their capital back. No investment is ever entirely risk-free, but a bond issued by a strong and stable government is pretty close to it.
Corporate bonds, on the other hand, generally carry a higher level of risk because the future financial health of the borrower is far less certain or predictable. The key difference between a corporate security and a government bond, of course, is the identity of the borrower – the bond issuer.
If you assume or accept that the creditworthiness of a particular government is unimpeachable – and that’s not true of all governments – then the risks associated with government bonds are relatively low.
But assessing the creditworthiness of a corporate is a much trickier proposition, and calls for as much equity analysis skill as debt analysis skill. Generally, the expected return from a corporate bond is higher than the return from a government bond for the simple reason that there’s more risk associated with a corporate bond and investors demand higher compensation for taking that risk.
“These spreads aren’t steady; they vary through time,” Brunton says.
But everything is relative. Brunton says recent government activity has seen yields on government debt decline.
“Governments, since the middle of 2008, have embarked on unprecedented actions to stabilise the global financial system,” he says.
That includes doing things like cutting interest rates to zero, in some cases, acting as guarantor for the banking system and creating very large stimulus packages. Yields on corporate bonds, being generally priced at a premium to government bonds, have therefore also declined.
But Brunton says that “corporate yields really aren’t that low, from a historical perspective”. “If we’re right…it holds that corporate yields will outperform government yields,” he says.
Brunton says Australian companies are issuing debt securities “at a pretty fast clip” and there have been half a dozen notable corporate bond issues recently, including by Leighton, Australian Prime Property Funds (APPF), Holson, Tabcorp (retail and wholesale issues) and, more recently, Wesfarmers. Brunton says not all corporate bond issues are created equal, and investors need to know all they can about terms and conditions and covenants before investing.
