The price of predictability

While fixed income can still offer compelling value for advisers and investors, there are a few road traps to be mindful of, Ross Kent writes. 

Traditionally, most investors have regarded fixed income as the “boring” part of their portfolios – the rather dry, technical, safe component intended as a buffer against volatility in the larger and more interesting equity portion of their investments. But this attitude is beginning to change.

As the investor demographic in Australia and other developed countries ages and moves closer to, or into, retirement, fixed income is playing a larger and more important part in portfolios and investors are beginning to accept they need to know more about the subject. How can advisers help them?

The key, in our view, is to simplify the concepts as much as possible and to give a fair and balanced assessment not just of the benefits of fixed income but also the risks – an aspect of fixed income that many investors either misunderstand or underestimate.

Demystifying fixed income

Strictly speaking, a fixed income investment is any investment which is attractive mainly for its ability to produce a predictable stream of income. In this, fixed income differs from equities, which tend to be valued for their potential to grow capital.

Another point of difference is that a fixed income investment is a loan: after a period of time, the investor (lender) expects his or her capital to be returned. Equities, however, are risk capital: the only way for an equity investor to liquidate a shareholding is by selling it.

The simplest form of fixed income investment is the term deposit, which involves depositing money at a financial institution for a fixed time in return for a fixed rate of interest, usually at a margin above the cash rate.

For investors in managed funds, the most common form of fixed income investment is a bond, which is a security issued by a government or company. A bond consists of principal (or face value), a coupon (interest payment) and a maturity date, when capital is repaid and the final interest payment made.

When investing in a bond, investors need to consider three things: the creditworthiness of the borrower (that is, the perceived risk of the investment), the yield being offered and the appropriateness of the maturity date, given the investor’s own time horizon.

Each of these characteristics needs to be assessed in relation to the others. A bond’s yield for example–that is, the coupon expressed as a percentage of the bond’s market price will be influenced by risk perceptions and maturity date, as well as by other factors.

Understanding yield

A common source of confusion for many first-time bond investors is the fact that bond yields are inversely related to bond prices. In other words, yields fall as prices rise and vice-versa. The idea that a bond-market “rally” is characterised by a broad fall in bond yields can appear counter-intuitive.

It helps to remember the mathematical relationship between principal, coupon and yield. The yield on a bond with a principal of $100 paying an annual coupon of $5, for example, is 5 per cent when the bond trades at face value or par. If it trades at $110, that $5 coupon translates to a yield of 4.5 per cent.

Conversely, if the bond’s market price falls to $90, the yield rises to 5.5 per cent. (As well as explaining the dynamics of yield, this illustration serves as a handy reminder for fixed income investors that bond prices can go down as well as up). 

The factors that determine a bond’s yield are specific and general. The specific factors tend to be the creditworthiness of the borrower and the maturity date of the bond, both of which influence the rate at which the coupon is set and the price at which the bond is issued.

If the borrower’s creditworthiness is good, the risk of default–that is, the possibility that the investor might not receive all interest payments or the return of capital–will be low, and so the interest paid to the investor will be low, too.

The same applies if the maturity date on the bond is near-term (say, three or five years as opposed to 10) given that, from an investor’s perspective, a short-term debt exposure is deemed to be less risky than a long-term one. Coupons will be higher for less creditworthy and/or longer-term bonds.

General factors affecting yield are those that tend to influence bond prices, and these include the outlook for interest rates and bond-market supply and demand. The interest-rate outlook is particularly important, as this can affect supply and demand.

Broadly speaking, bonds tend to perform better (that is, demand for them increases and their prices rise) in uncertain economic environments where growth and confidence are low and governments are taking steps to support economic activity by, for example, reducing official interest rates.

A slowdown in economic growth typically implies weaker or negative capital appreciation for equity markets (and higher risk, as more companies might go bankrupt) and can often result in a broad reallocation of capital from equities to bonds until market conditions improve.

Low economic growth usually implies low or falling inflation and is good news for bonds, as rising inflation undermines the real value of fixed income returns over time. Similarly, low or falling official interest rates may, for income investors, increase the relative attractiveness of bonds.

Not all bonds are equal

While certain characteristics are common to nearly all bonds, there are many different kinds of bonds and investors need to understand the key differences between them. An important difference between government and company or corporate bonds, for example, is risk.

In the context of bonds, risk is normally regarded as a borrower’s ability to meet its obligations on interest payments and the repayment of capital. In other words, the more secure and manageable a borrower’s cash flows, the more attractive a risk the borrower is considered to be.

On this basis, governments rank at the bottom of the risk spectrum because they can levy taxes. Companies, even well-managed ones, are deemed to be higher-risk because their cash flows are always to some extent hostage to the business cycle and other factors beyond their control.

There are, of course, different degrees of risk between one government borrower and another, and one corporate borrower and another, and investors can distinguish between them by using credit ratings assigned by ratings agencies such as Standard & Poor’s, Moody’s Investors Service and Fitch.

Bonds issued by borrowers with high credit ratings (AAA or AA+, for example) tend to be priced more expensively than those issued by borrowers with low or sub-investment grade ratings (below BBB- on the Standard & Poor’s scale, for example).

In bond-market parlance, an “expensive” bond is one on which the yield is low in relation to a pricing benchmark. In Australia, such benchmarks tend to be the yield on a Commonwealth government bond with a matching maturity date or (in the case of corporate bonds) the bank bill swap rate.

A cheap or high-yielding bond is usually priced that way because it is perceived as high-risk.

Also worth mentioning in this context are asset-backed bonds, on which the underlying cash flows come not from government tax flows or the broad activities of a business but from a discrete pool of assets, such as home loans or credit cards.

These “structured” investments can include credit enhancements which result in bonds with ratings higher than would otherwise be merited by the credit quality of the underlying assets. While their returns may appear attractive we think that, as a rule, they should be approached with care.

Real risks

Other types of bonds are floating-rate notes and convertible notes or hybrid securities. The coupon on floating-rate notes is set at a margin above a floating-rate benchmark, such as the cash rate, so it is a “fixed income” investment in the sense that the coupon moves in lockstep with the benchmark.

Convertibles and hybrids are a cross between a corporate bond and a share. They pay interest until maturity, after which the investor can choose to have the capital returned as cash or as equity. The interest payments can be higher than those on normal bonds, reflecting higher underlying risks.

These securities, together with certain classes of Australian government bonds, are traded on the Australian Securities Exchange. For most investors, however, managed funds represent a more straightforward and flexible way of accessing fixed income investment opportunities.

One benefit of managed funds is liquidity, meaning that investors can enter and exit investments relatively cheaply and quickly. Funds that offer access to a range of global opportunities may also increase Australian investors’ scope for returns and the risk-mitigating benefits of diversification.

While it is generally true that corporate bonds are less risky investments than equities, corporate bond issuers can go bankrupt and bondholders can potentially lose their capital. Importantly, however, bondholders rank ahead of shareholders in the event of a corporate liquidation.

Government bonds can also be surprisingly risky–as owners of Greek government debt learned to their cost during the European sovereign debt crisis. The bottom line is fixed income can be complex, and that makes it an area where well-prepared advisers can add a great deal of value for their clients.

Ross Kent is an executive director at AllianceBernstein Australia Ltd.