Direct fixed income versus annuities and funds

Elizabeth Moran makes a comparison between direct fixed income investment and annuities, and then with funds.

This article will provide a brief comparison of direct fixed income with the provision of an annuity from an annuity provider, which focuses on the following areas of comparison: return, risk, diversification, liquidity, flexibility, and ongoing fees.

The article will then compare two formats for holding fixed income – direct ownership compared with ownership through a fund. Here, the following areas of comparison are made: fees, diversification, liquidity, and other issues.

Direct fixed income versus annuities

In general, the benefits of direct fixed income can be summarised in the following brief comparison:

Return

Annuity providers offer returns of around swap plus 100 basis points (bps). However, it is difficult to estimate exact pricing as annuity pricing is not publically available.

In contrast, one can easily derive pricing information on direct bonds.

Currently, direct bond portfolios can generate over 200 bps to swap. Typically, the direct bond portfolio should yield at least 100 bps more than an annuity. 

Risk

The direct bond portfolio is also likely to have a higher weighted average credit rating than the securities purchased by the annuity provider (assuming most of the securities in an annuity portfolio are in the BBB range).

In terms of an annuity, the single provider guarantees the investor repayment.

By contrast, the direct bond portfolio has a variety of issuer exposures, and each issuer is responsible for meeting interest and capital repayments.

In other words, it is logical, from a risk perspective, to expect that one would prefer to receive a variety of issuer guarantees from a diverse range of companies, as opposed to relying on one company for the annuity payment.

Diversification 

Allied with considerations of risk is the consideration of diversification. Investing in annuities exposes an investor to the strength of the company, and that company alone.

A direct investor enjoys direct control of their portfolio, which would have a variety of issuers, not just one as supplied by the annuity provider.

Also, investors can choose which sectors they prefer and how many issuers constitute their portfolio.

Liquidity 

A direct bond portfolio is comprised of relatively actively traded bonds, where large institutional investors trade on a regular basis, so that liquidity is possible in most cases – although liquidity varies with market conditions.

While liquidity may be available in various formats from the annuity provider, it is usually costly, with exact details of these costs hard to obtain in most cases.

Flexibility 

Direct portfolios offer complete flexibility to change the portfolio at any time, since the underlying securities can be traded if risk preferences change, or if changes to the term of the portfolio are required.

While variation to an annuity is possible, the variation comes at a cost which can be higher than the costs of trading a direct portfolio, although details of exact annuity charges are difficult to obtain in most cases.

Ongoing fees 

While the annuity provider pays fees to ‘up-front’ distributors, some ongoing fees apply. In addition, the annuity provider keeps the difference between the investment portfolio of around 200bps and the payout level, or around 100 bps over the swap curve.

In other words, the annuity provider keeps roughly half the investment return, so as to fund regulatory costs, management costs, and advertising budgets.

In comparison, the direct portfolio has no ongoing fees and is better aligned to the direct investment needs of the self-managed super fund (SMSF) sector.

In other words, the direct portfolio has higher return, higher credit quality, and a range of other benefits that give control back to the investor, while costing the investor much less.

Direct portfolios can, therefore, compete well with annuity providers, and further investigation is well worth the time.

Direct fixed income versus funds

Direct ownership, in many ways, provides a much better way to access bonds when compared to managed funds.

Direct ownership allows a degree of investment tailoring which cannot be provided through the use of managed funds.

Since bonds have very different correlation characteristics to equities and are typically, although not universally, of high credit quality, the case for direct ownership remains compelling.

Key advantages of direct ownership include the following.

Fees

Both direct ownership and managed funds incur bid/offer spread fees taken by the broker on the purchase or sale of a bond.

The fees vary according to credit quality, liquidity and parcel size. High quality credit will have a low bid/offer spread, while low credit quality will have a higher bid/offer spread. 

In the case of a fund, or unit trust, these bid/offer spreads effectively translate to what is known as an ‘in-out’ spread or a transaction spread.

A unit trust with a government benchmark will have a lower in-out spread than a unit trust that has a low credit quality corporate benchmark.

Also, the higher the alpha target or the amount targeted above the benchmark, the higher the in-out spread. These transaction costs are common to both managed funds and to direct ownership of fixed income.

Direct bond owners pay no ongoing management fees, while funds have fees that can be substantial.

Funds with either lower quality benchmarks, or higher alpha targets, or both, will have higher management fees.

In a low return environment, management fees are important, and fees of more than 50 bps might represent roughly 10 per cent of return if the bonds earn roughly 5 per cent per year.

Diversification

Diversification in investment management refers to reducing risk through selecting a diversity of assets.

Typically, diversification is applied to assets that are higher risk, such as equities, or those securities with perpetual dividends streams.

These assets are also highly volatile, while debt is much less volatile.

If equities are less than perfectly correlated, which they typically are, then the ‘diversified’ portfolio will have less risk than the weighted average risk of its constituent assets. 

On the other hand, where securities are more correlated the issue of diversification really becomes important when the credit quality of the issuer is low, and when the issuer is not regulated by institutions such as the Australian Prudential Regulation Authority.

In other words, the issue of diversification is much less important in the case of fixed income when compared with equities, since the debt holder is typically in a far superior position on a bankruptcy (when compared with an equity holder) and the credit quality of the vast majority of fixed income securities is sound.

In many cases, ongoing fund management fees may outweigh the benefits of diversification.

In addition, adequate credit research can really assist investors in the areas where diversification is relevant, since some risk needs to be taken to obtain return. 

The arguments for diversification really become relevant in a limited number of cases where investors have no guidance on credit and are at the riskier end of the credit spectrum, especially below investment grade.

Moreover, the ability to break down bonds into smaller parcels effectively solves most of the diversification problem for many investors. Historically, bonds were only available in $500,000 face value parcels (see Figure 1).

Liquidity

The liquidity of most investment-grade Australian direct bonds is excellent.

In the case of the credit sub-component, the liquidity of individual securities varies greatly, and is more than adequate in most cases, as these securities are investment grade and are actively traded between competing institutional fund managers on a daily basis. 

By way of contrast, there is no active secondary market in the units of a fund.

Also, it needs to be emphasised that funds access the same liquidity as the direct bond holder, although the direct bond holder knows what security is held, while a unit holder in a fixed income fund does not know what underlying instruments are held. 

In some cases, the investment mandate may have permitted the purchase of illiquid, or sub-investment grade debt, which will cause liquidity issues for the fund in a time of stress.

In other words, liquidity in credit is not an issue in the majority of cases in the Australian fixed income market, and the liquidity of the security can be carefully calibrated in the case of a direct bond, while the unit holder in a fixed income fund loses control over liquidity.

As liquidity falls, investors are typically rewarded with extra yield in the form of an illiquidity premium, yet the direct holder has control over what he buys and sells, while the fund investors do not.

Some inflation-linked securities, such as the semi-governments, the major banks, and other issuers reflect this premium.

In other words, rewards for liquidity are apparent, and direct ownership can assist with the effective targeting of these premiums, with a fully transparent approach.

While liquidity is generally thought to be higher in a managed fund, the reality is there is no liquidity advantage in the underlying fund when compared to the direct investment.

Moreover, the mixture of asset types in managed funds can impede liquidity in the case of a crisis situation, where the manager can only liquidate certain parts of the portfolios and not others, leading to fund liquidity freezes.

Direct ownership avoids these problems, as liquidity attaches to individual securities, not to the total portfolio.

Other issues

Several other issues require consideration, such as the degree to which portfolios are transparent. One of the main benefits of direct ownership is that investors can build a portfolio that suits individual risk, liquidity, maturity, and return preferences.

These issues are summarised in Figure 2.

Conclusion

This article looked at the benefits of direct fixed income in two main contexts. 

First, direct fixed income was compared with annuity products where a fixed income portfolio effectively replicates an annuity-style cashflow.

While using an annuity provider remains a valid form of investment, the use of a direct portfolio of bonds has many advantages.

Bearing in mind that SMSF portfolios are typically designed to avoid ongoing fees, yet annuity providers are offering products that have large fees embedded in the product, a bond portfolio is better aligned to direct investing.

Annuity providers keep most of the investment return of around 100 bps, or more (200bps total return less the investment payout of 100bps).

Part of the proceeds kept by the annuity providers are used to pay for advertising and part are kept to pay for the costs of regulatory compliance, apart from other things.

By analysing the annuity product, investors can then attempt to replicate the characteristics by using bonds. Generating the same outcomes by using direct securities enables:

• Direct control over risk;
• Greater diversification;
• Avoidance of fees;
• A higher return.

Second, this article compared direct fixed income with holding fixed income via a managed fund.

Importantly, fixed income funds may suit some investors and there is no fundamental problem with fixed income funds. Rather, this article highlights the benefits of direct fixed income.

They allow the investor to control their own risk reward targets, as well as liquidity and maturity, at a lower cost with no ongoing fees.

Elizabeth Moran is director of education and fixed income research at FIIG Securities.