The changing face of bonds

With traditional fixed income delivering lukewarm returns of late, protecting assets from the shocks of volatility may soon require a move into unconventional areas

The average conversation around bonds will almost always refer to the traditional type: government. But lately, government bonds have not been the most positive topic.

Bloomberg data shows that yields for government bonds around the world have fallen to record lows, with some reaching negative levels.

More than $7 trillion of government bonds offered yields below zero globally in February, making up about 29 per cent of the Bloomberg Global Developed Sovereign Bond Index.

Moreover, yields are not expected to rise again anytime soon, says AllianceBernstein (AB) portfolio manager for fixed income, John Taylor.

The end result? Widespread uncertainty about whether bonds in general should still be considered 'safe haven' investments in times of volatile equity markets.


"People use bonds for a couple of purposes: One is to generate income, and the second is to balance the risk of their equity holdings," Mr Taylor says. "With low yield levels, the income generation is limited. I think that's why people are wondering whether bonds still belong in that balanced universe."

Some say they do still belong – just not the ones you are thinking of.

Instead, an area of corporate bonds has started to look like a good place to take on credit risk while exchange-traded bond units (XTBs) are proving to be insensitive to market turbulence.

At the same time, others say high-yield hybrids are becoming an attractive alternative for investors with locked confidence in Australia's banking system.

The key is to be diversified, Mr Taylor says, and taking a peak outside the norm is a good way to get there.

"Don't be overly concentrated in just a handful of bonds," he says. "Take a very diversified basket approach because we are in an uncertain world. A lot of people, when they talk about bonds, they just mean government bonds.

"But there is a whole other world out there that people are unaware of and really just treat bonds as if they are all the same when they ought to give you very different outcomes."

Alternative hot spots

Even though the local bond index returned 1.2 per cent in January, it was still not enough to offset the 5.5 per cent down that occurred in equities, says Anthony Kirkham, Western Asset Management's head of Australia and New Zealand operations and investment management.

"It all comes down to the fact that yields are so low that people are forced to take risk to get some sort of return in a lot of these countries," he says. "But you need to be selective rather than thinking, 'Oh, I heard bonds are no longer of any value'. Well, that's not true.

"There are markets that are valuable and I think the Australian exposure is still worthwhile."

Corporate bonds and their widening credit spreads have caught Mr Kirkham's eye and these have become noticeable in the past six months, he says.

This is especially true in Australia, where more companies are demonstrating stability.

"We still see that fundamentally corporates, particularly in Australia but in other parts of the globe as well, are looking attractive," he says. "They generally have strong balance sheets, still [have] got good profitability, and those fundamentals make these sorts of investments more attractive."

Nevertheless, industries matter when looking to invest in corporate bonds, Mr Kirkham adds, and the ones to avoid include the energy and commodity sectors.

"Because they can't sell oil at prices they originally thought, the cost of production is higher than the cost of the sale or the good. So those businesses are in trouble," he says.

"It comes down to your analysis, doing the work and understanding the company. I think there are some good opportunities across numerous sectors, but talking about the ones you want to avoid, the energy sector is one of them."

The more promising industries include the financial space. Regulation in Australia that is forcing banks to hold greater capital is sending out waves of fear, and therefore raising yield in a less risky area, Mr Kirkham says.

"It means [banks] have to either issue equity or issue different forms of bonds and that is scaring the market because big numbers are being thrown around," he says.

"So you're seeing spreads widen but the fundamental thing there is that banks are much safer than they used to be."

eanwhile, Chris Andrews, La Trobe Financial Asset Management's vice president and chief investment officer, says property credit investment is "one of the most powerful forms of investment" in fixed-income portfolios.

"It has particular value as a floating interest rate investment for retail investors," he says.

"Structures are simple and transparent, meaning that risks can be understood and assessed.

"Capital security is a key feature, with portfolios typically benefiting from strong asset backing. Finally, the income profile is strong – generally providing a substantial premium to alternatives like cash and term deposits."

AB's Mr Taylor would agree that corporate bonds look attractive, even outside Australia. However, he warns that it is not quite time to sway too far from credit ratings when making decisions.

"What we're not doing is advocating adding a lot of very low-rated, high-yield type of bonds at this juncture," he says.

"We think it's too early to be making those kinds of moves.
"So, we would advocate that you can take credit risk but you should be higher up the rating spectrum.

"If you focus your attention more on the lower-risk side of the corporate bond world, and also combine a relatively short maturity bond, you don't have to take on a lot of interest rate exposure or credit risk to earn a fairly reasonable yield."

Playing defence

As appealing as some of these corporate bonds may sound, gaining access to them has not always been easy for retail investors.

That's why Richard Murphy, chief executive and co-founder of the Australian Corporate Bond Company (ACBC), said the firm launched XTBs – an ASX-traded product that gives investors access to big-name companies such as Telstra and Woolworths.

"There is a lack of senior, more stable corporate bonds on the ASX. The big companies issue bonds but only for the wholesale market and they will not do it on the ASX," he says.

"What we've done is buy the bonds in the wholesale market in $500,000 parcels and then we make those bond returns available in smaller amounts around $100 on the ASX."

According to Mr Murphy, interest in XTBs grew when investors began seeking ways to protect their assets from volatility shocks – a defence strategy, considering that bonds are known to have negative correlations with equities.

"So when equities plunge, like they did in the last five to six months, bonds actually go up in value and that provides protection," Mr Murphy says.

"We had a look at all of our 33 XTBs to see how they've gone over the last year – which was a year from hell for equities – and all 33 of the bonds were in positive territory. They ranged from plus-1 per cent to plus-10 per cent in terms of total returns.

"That's why senior bonds are important because you do get that portfolio protection," he says. "While your equities plunge, your senior bonds increase and therefore your portfolio is protected to some degree by the defensive assets you put in it."

There is, however, a reason why government bonds are more common than corporate, says Grant McCorquodale, head of personal and intermediary clients at FIIG Securities – it's because the risks can differ.

When companies collapse, there is a chance bondholders will lose their investments, although it is rare, he explains.
"Risks only exist if a company falls into administration. The first group of holders that gets wiped out are the shareholders, so they take the first loss of capital," says Mr McCorquodale.

"Then you've got your hybrid holders, they get wiped out. And then you go into the secured and non-secured debt marketplace.

"So even on the rare occasion that a company may not continue, you still have a very real return of capital opportunity."

Aside from returns, the price of the bond may be affected by forces such as interest rates and "small degrees" of how a company is operating, Mr McCorquodale adds, but those variables are a fraction of what equity market volatility can bring.

"As long as the companies are operating, they are paying their debts and profitability is secondary," he says.

Hybrids – are they too risky?

While the risks of corporate bonds seem low, the same has not generally been said of their hybrid sisters. The securities, which offer blended features of both bonds and shares, were flagged by ASIC as "complex products".

"Even experienced investors will struggle to understand the risks involved in trading them. If you don't fully understand how they work, you should not invest," says the warning on ASIC's website.

Bell Potter Securities' head of fixed income, Barry Ziegler, describes hybrids as securities that behave like bonds in good times, but like equities in bad times.

"In other words, in good times, you're going to get your distribution regularly and eventually, you're very likely to get your principal back," he says.

But unlike bonds, hybrids do not have a maturity date; rather, they have what is known as the "first call date" which is when the issuer expects to repay the holder, although this is not mandatory.

Mr Ziegler, however, believes the risks of hybrids fall considerably when the issuer is a major Australian bank, thus presenting an opportunity for investors looking for extra yield.

The banks here are "unquestionably strong" and the possibility of one of their hybrids going wrong is "extraordinarily unlikely", he says.

"It's virtually like getting on to a Qantas jet and essentially listening to the safety instructions and saying, 'Hey, this is dangerous. I am getting off'," he says.

"You know full well that Qantas is not going to crash but there is a possibility. You have to ask yourself with hybrids, am I getting rewarded for taking the risk of the issuer?"

That argument has been circulating recently with the Commonwealth Bank of Australia announcing in February that it will offer a new Tier 1 hybrid product, the CommBank PERLS VIII Capital Notes.

However, according to fixed income research house BondAdviser, the hybrid is priced below fair value and investors should steer clear.

"Therefore, post-listing, if the security was to move to this fair margin alongside similar bank hybrids investors would see a capital loss of approximately $2.50 per $100 face value," BondAdviser said in a report. "On the basis of the indicative margin range of [5.20 – 5.35 per cent] we recommend investors do not subscribe."

ACBC's Mr Murphy believes investors should approach the new product and other hybrids as though they were equity, and not fixed income.

"Some of them are extremely equity-like so people should not be fooled into thinking that they bought a bond when they've bought a hybrid security," he says.

"If the company gets into trouble, or even looks like it might, then you're going to have to be converted into equity at the worst possible time.

"And in the meantime, you have significant volatility as the market assesses the probability the hybrids may need to be converted or the call date may be deferred."

AB's Mr Taylor would agree. He says there is even a move in Europe to prevent direct sales of hybrids to retail investors.

"I'm not saying that hybrid bonds are a no-go for everyone, but there is a lot more downside risk than people perceive.

"They simply look at whoever the issuer is and if that if that is a fairly strong issuer, they are happy to take on more yield that these hybrids offer," he says.

"For a lot of those investors, they will earn that yield through time but I think there is a certain part of the market who own them and are unaware of the risks associated with those hybrid securities."

The right investor

A move away from traditional bonds may result in higher yields, but it is not a recommended choice for investors with low risk tolerance.

AB's Mr Taylor says whether they invest in high-yield corporate bonds should depend on which stage of life the investor is at.

"Those who are in the early stages of paying into their super fund and can take a little bit more risk, some of these high-yield bonds would represent a pretty good investment and probably give you a better risk reward than some equities at this point," he says.

The same goes for hybrids, says Bell Potter's Mr Ziegler, noting that these are also for "set and forget" investors.
"They are for people who can buy and forget and just enjoy the income. They don't trade the security and such," he says.

La Trobe Financial's Mr Andrews says one rule of thumb to determine the percentage to allocate to stocks is to subtract the investor's age from 100.

"The remainder would be invested in capital-stable, income-producing assets like fixed interest," he says.

The key risk that investors should avoid near retirement is sequencing risk.

"Sequencing risk is the risk generated by asset class volatility. Thus, for example, whilst equities might achieve an 8 per cent return over a 60-year investment timeframe, actual outcomes for investors will be substantially worse if bear markets occur at or near retirement, when the asset pool at risk is at its largest," Mr Andrew says.

"The consensus strategy to manage this risk is weighting portfolios away from risky assets like equities at and near retirement.

"The compounding effect of the larger asset base means that capital-stable, income-generating investments will both protect the underlying asset pool and provide significant retirement income for the investor."

FIIG Securities' Mr McCorquodale believes that with more Australians moving toward retirement stages, the demand for fixed income will take off.

"The private investor is living longer and is looking for secure, income-producing investments that are reliable as opposed to equity," he says. "Anyone moving into retirement knows they cannot take that equity journey and we're now five years into the baby boomers retiring.

"We're at the start of a major transition of those people setting up their retirement security and part of that is to take an increased level of secure investments such as fixed income."

The changing face of bonds
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