Returning to the safety of bonds

Many clients are currently seeking safer asset classes to protect their wealth from further market downturns. Tamara Radice examines ways in which bond portfolios can deliver high returns.

Are you one of the many financial planners whose clients are seeking safer asset classes to protect their wealth?

Are you unsure of the options? Bonds could provide the solution.

They are a safer asset class than shares as the investments sit higher in a corporate or bank capital structure (see Figure 1), they pay a known return, and in most cases capital is repaid at maturity.

Figure 2 shows the performance of Commonwealth Bank securities throughout the global financial crisis.

Equities or shares were clearly the most volatile, hybrids a little less so, and bonds (in this case subordinated debt) sitting higher in the capital structure performed most consistently, protecting investors’ hard-earned capital.

Global volatility is set to continue.

In particular, US debt, possible (in my opinion, probable) debt default by EU countries, economies recovering or experiencing natural disasters (Japan, New Zealand, Australia, Somalia), and an Australian carbon tax all make for a period – perhaps extending to years – of share market volatility.

What assets do your clients hold that will protect their wealth? Does their asset allocation match their age profile?

Older clients – especially those no longer earning an income – have little or no capacity to recover lost capital. To ensure they have enough capital to live well for the remainder of their years (with some left over to provide an inheritance) you’ll need to allocate the funds to relatively safe asset classes.

One rule of thumb we use is that the maximum equity holding an investor should have is 100 minus their age. So a 70 year old investor would have a maximum allocation to equities of 30 per cent.

Many Australians are great fans of shares, and with good reason. Resource stocks have performed well, but consider what percentage they make up in your clients’ share portfolios and total portfolios. BHP Billiton – the largest company on the Australian Stock Exchange, worth approximately $238 billion – is rated by Standard and Poor’s (or equivalent) as ‘A+’; four notches lower than the highest ‘AAA’ rating (only attributed to the Commonwealth Government in Australia).

That means its debt is considered to have a low probability of default. BHP’s shares – which are lower in the company’s capital structure – are higher risk. Part of the reason BHP’s debt is only rated ‘A+’ is that the company largely trades in commodities.

Commodities are cyclical, so we know that their prices will go up and down, and will impact earnings. 

Consider if your clients hold a large proportion of their wealth in a resource company that only produces one commodity – it is going to be considered very high risk. Is the asset still appropriate?

So how do you diversify and protect your clients’ wealth?

Bonds – and if your clients already hold some, maybe more bonds. Global uncertainty will still impact debt markets, but to a lesser extent. In the majority of cases, investors know they will receive their capital back on a known date.

To demonstrate current opportunities, we have put together a portfolio including household names such as National Australia Bank and AXA that can achieve a 10 per cent return while providing a weighted average rating of ‘A+’ (the same risk attributed to BHP Billiton debt).

In rating agency terms, that represents just a 0.61 per cent chance of default over a five year time horizon.

However, before we move on, it is important to point out the shortcomings:

1. This portfolio is only available to sophisticated investors, as a number of the bonds can only be sold in minimum face value parcels of $500,000. In fact, the total funds needed to replicate the portfolio are $1.75 million – not exactly small change. 
   However, a similar portfolio based on an investment of $350,000 (available to all investors) still returns over 8.6 per cent, and could be structured by substituting a few names – albeit, with a slightly lower weighted average rating of ‘A’ (see below).
2. Diversity is only moderate, having just four bonds – two of which are insurers – plus a small allocation to a Rabobank ‘At Call’ account. Also, three of the four bonds are Tier 1 hybrid securities. Typically, we would recommend a more diversified portfolio with at least five bonds from a mix of industries.
3. The portfolio is better suited to hold to maturity investors as Tier 1 securities could see some liquidity issues if the market is stressed at a time when these securities need to be sold quickly.

Finally, it is important to point out that three of the securities are Tier 1 callable securities, and the expected yield is based on the assumption all are called at first opportunity (which we do expect to occur). If not called, these securities are technically perpetual.

The current market yield/swap curve and inflation expectations are also used to estimate the yield to (expected) maturity for the floating rate and inflation linked bonds in the portfolio.

Despite the abovementioned shortcomings, the ability to achieve close to a 10 per cent expected return from a high quality portfolio is worthy of assessment. 

The National Capital Instruments is only available in minimum parcels of $500,000 face value.

However, by replacing it with National Wealth subordinated debt (a wholly owned subsidiary of NAB), a similar portfolio with a return of 8.69 per cent and a weighted average rating of ‘A’ can be achieved (‘A’ represents a 0.64 per cent probability of default over five years).

Total outlay for this portfolio is $350,000. 

In conclusion, it’s worth taking the time to assess the risks within your clients’ portfolios. Is their asset allocation diversified enough to withstand an extended period of share market volatility?

Does it suit their age profile and capital preservation goals? (Particularly relevant for those in retirement and pay-down phase.) Bond portfolios can offer high, known returns that are close to equity returns, yet are significantly lower risk and generally less volatile in uncertain markets.

For additional bond portfolio tables click here.

Tamara Radice is the director for institutional investment and planner services at FIIG.