“Governments have been doing a lot of issuance, but they do not really do much to vary the terms and conditions,” he says.
“The main ability they have to enhance the attribute of their issue is to issue them with a higher interest rate.
“Corporates, on the other hand, can provide covenants, to make this vintage of corporate bonds look very good relative to prior years.”
Understanding those covenants and having a deep knowledge of the financial health of the company issuing the bond are two critical pieces of information.
Brunton says AMP has an internal team dedicated to knowing that – and more – and they liaise closely with AMP Capital’s equities team. He says professional bond investors do not rely only on the ratings applied to bonds, but “have a commitment to form our own views”.
“At times, our [internally-derived] rating can be many notches away from the official rating,” Brunton says.
That’s when opportunities arise to add value – either by recognising that the risks associated with a particular issue are less than the yield would otherwise suggest, or by minimising the risk of capital loss by avoiding issues where the yield is inadequate compensation for the risk of the security.
Brunton says there are opportunities in the corporate debt markets now to lock in rates of return more generally associated with growth assets, but with far lower risk.
“You’d traditionally use equities or some kind of growth assets to get these sorts of returns, but you can now do that with corporate bonds,” Brunton says.
“I think a key consideration for advisers is around the fact that now is the time for corporate bonds versus sovereign bonds, given that corporate bonds can [also] form part of the defensive portion of your portfolio.
“The essence of the strategy has always been one of diversification, but particularly now in the ‘deleveraging’ stage of the economic cycle, you want an investment process that’s going to find you these deleveraging companies by doing your own research, and you want to have a diversified portfolio.
“Corporate bonds can’t double in value, like equities can, so the best thing is you get your money back. You need to avoid defaults, and make sure you’re not exposed to X-factors. “We would caution investors to think very carefully about diversification.”
AUI’s Bryant says the need for effective diversification and the analysis required to properly assess a corporate bond means direct investment by retail investors in the sector is not likely to catch on as it has in the government bond sector.
For a start, most corporate bonds are not issued to retail investors, so they need a minimum of $500,000 to invest. This severely limits the scope for diversification. The same issue is not quite as extreme in the government bond sector, because you don’t get nearly the same diversification benefit from buying more than one bond issued by the same government.
“If you have a one-off lump sum of money, and you want to park it [in a government bond] and not think about it too much, you can do that,” Bryant says.
“But managing a bond portfolio is also about some other things. One of them is duration.”
Duration is, simply, how long until a bond matures – or, in the case of a portfolio of bonds, the average time to maturity of all bonds held. For example, if you hold two bonds, one with 12 months to maturity and one with three years to maturity, the weighted duration of that portfolio is two years. “When you hold 100 securities, that [calculation] becomes a little more complicated,” Bryant says.
But if the average investor is restricted to buying only one bond, it’s not easy to manage duration.
Bryant says investors also need to understand where bondholders sit in the capital structure of the issuer. Corporate bonds, depending on the exact nature of a particular issue, sit somewhere between equity and bank debt. So bondholders are dealt with before shareholders but after the banks in order of priority when it comes to getting their money back, should the company fail.
Bryant says there are some interesting opportunities in the corporate bond market at the moment, given the strength of some of the bond issuers and the relative overpricing of risk at the moment.
“Using bonds instead of equity is where corporate bonds are playing an interesting role,” Bryant says.
When a company issues a bond, investors have the choice of buying the bonds or buying the company’s shares. If they buy the shares they enjoy theoretically unlimited potential upside, but there’s also a risk they could lose everything if the company fails. If they buy the bonds, on the other hand, they have limited upside – at best they will get their money back, but the interest rate is likely to be fixed – but less risk of capital loss (provided the bond is held to maturity). So investors have to decide which risk they want to be exposed to: the company’s underlying business (as a shareholder), or its status as a counterparty (as a bondholder).
Bryant says there are examples where a company’s status as a counterparty is unquestioned even as the outlook for its business remains somewhat uncertain – making the corporate bond the more attractive option, at least for the time being. Managed funds remain the main vehicle used by retail investors to gain exposure to fixed income markets, and as a generalisation, adviser and investor knowledge of the sector is less well developed than knowledge of, for example, equity markets.
