Fixed investment risks and opportunities

With fixed interest investments becoming increasingly popular with all types of investors, Michael Frearson writes it is crucial that they know what to look out for.

With ongoing volatility in the equity market and falling cash and term deposit rates, it seems investors are showing increasing appetite for fixed interest investments.

This demand is coming from both investors with high exposures to growth assets and those at the other end of the risk spectrum, investors with large cash and term deposit portfolios.

During the past 12 months, there has been a large number of listed interest rate security initial public offerings, and also the listing of fixed interest exchange-traded funds (ETFs).

This has increased the range of income-earning listed investments available for investors. These new developments have been timely, given the above-mentioned trend of increasing investor interest in lower-volatility income-producing investments.

Listed interest rate securities and ASX market growth

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The growth in the range of Australian Securities Exchange (ASX)-listed interest rate securities has been significant, with the sector market capitalisation reaching all time highs of approximately $29 billion as at June 2012, and there has been further material growth since then. (See Graph 1)

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There have been approximately 15 new securities launched by a range of domestic financial issuers – for example banks and insurance companies, and domestic industrial corporate companies – which together have raised approximately $10 billion from investors.

This growth has materially improved the sector’s diversification and reduced concentration risks, although the major banks still dominate the sector, accounting for almost 60 per cent of outstanding securities.

Key drivers of this increased issuance are the needs of the borrowers themselves, the companies that issue these securities.

Companies and banks continue to face elevated borrowing costs and are looking for diversification in their own funding sources.

For banks and insurance companies especially, there are upcoming regulatory changes regarding the treatment of hybrid and subordinated capital sources, which have encouraged issuance prior to the end of the 2012 calendar year, when the new rules are expected to take effect. 

In addition to the need for funding diversification, the prospect of favourable treatment by credit 

rating agencies and subordinated securities with some inbuilt flexibility for the issuer, have all contributed to the large growth in corporate issuance of fixed interest securities.

This demand from the issuers for these securities has coincided with strong demand from investors looking for high yielding investments with a different risk/reward profile than equities.

As a result, the majority of larger companies that have come to market have been able to raise substantial amounts of capital. 

Taking all of these factors into consideration, we expect the growth in the ASX listed interest rate securities market to continue.

The rise of fixed interest ETFs

The listed ETF market has also sprung to life since the beginning of 2012, due to regulatory changes that have opened the door for ETFs to be listed. ETFs are almost identical to traditional unlisted managed funds, with the key difference being they are listed on the ASX.

The market has grown to around $125 million, with nine different fixed interest ETF securities now listed from a range of providers.

A range of fixed interest ETFs is listed, which provide investors with access to more traditional fixed interest investments such as Commonwealth Government Bonds and State and Territory Government bonds.

Due to the high quality, and recent movements in Australian bond yields, the expected yield to maturities on the underlying portfolios is often not much higher than the current cash rate, and this current low yield is no doubt contributing to the slow take-up among Australian investors.

We expect the range of fixed interest ETFs and market capitalisation of the sector to continue to grow during the medium term, and as it grows the diversification potential will increase, given the new types of fixed interest exposures the ETFs will provide to the listed market.

Opportunities for investors

There are key differences between fixed interest ETFs and the listed interest rate securities market.

While the current range of ETFs provide very high credit quality (mainly Government debt) and fixed rate exposure, yielding three to four per cent, the listed interest rate securities market is generally floating rate subordinated debt or hybrid securities, with a higher yield, generally 6.5 to 7.5 per cent, but with a higher risk profile.

By having improved access to both high quality Government securities through ETFs and corporate debt and hybrid securities, it provides investors with greater choice to select what best suits their risk profile and investment objectives.

The growth in the range of listed fixed interest investments has provided investors with a range of new opportunities, which generally are higher in the capital structure than equities and display materially lower volatility than equities, while having an attractive regular income stream. 

The growth in the listed interest rate securities market in particular has materially improved the quality and diversification of this sector. Investors have been attracted to the relatively high yields, but they need to remember these securities are not risk-free and they have a high yield partly due to their subordination and flexible terms of issue.

With reward comes risk

While the growth of this asset class provides many opportunities for investors, they also need to be educated about some of the risks and considerations.

One potential area of confusion for investors can be the wide range of security types within the listed interest rate securities universe, such as senior bonds, subordinated notes, and preference share (hybrid securities).

Each of these has different terms of issue and can have many embedded risks, which need to be clearly understood prior to investment. 

Another consideration they need to be aware of is the potential for the deferral of the income stream (in many securities the income payment is not cumulative if not paid at the expected time).

Additionally, the security may remain outstanding for a long period of time (sometimes up to 60 years or even perpetual), rather than be redeemed at the first call date (generally five to six years from issue date). 

Some of the new bank converting preference share structures have inbuilt loss absorption characteristics, which can result in conversion into equity at a premium to the current share price.

Effectively investors can be short a put option in the equity – a characteristic that is not widely understood.

Additionally with all credit securities, there is the risk of default in that the borrower may not be able to pay back their debts, and this is a key point that advisers need to share with their clients.

What lies ahead?

Fixed interest investments are attracting greater interest among investors as the range of opportunities and solutions available continues to expand.

The listed fixed interest landscape has evolved and it is important for advisers to keep abreast of the changes and keep informed about some of the more sophisticated solutions that investors may now be exploring.

This is a complex space, but as investors continue to seek alternatives to equities, or higher-yielding alternatives to cash, it is a path for advisers that is well worth navigating – and one that investors will expect their advisers to help them travel.

Michael Frearson is a portfolio manager at Macquarie Private Portfolio Management.