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rethinking income &

diversification

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C O N T E N T S

Rethinking income and diversification

Tapping into the world of bonds

How are they traded?

Are bonds the same as hybrids?

Risks associated with investing in bonds

Mitigating the risks

Comparing income sources

Why invest in bonds?

What is the best way to invest in bonds?

Conclusion

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I N T R O D U C T I O N

Market swings are now a normal part of investing. Hairy curve

ball moments, including central bank actions and geopolitical

concerns, are factors which continue to rattle markets everywhere.

On the local front, a low cash rate looks like it’s here to stay.

Investors are now realising the importance of finding investment

options which offer good, consistent income.

Fixed-income allocations like bonds are one defensive strategy

investors can use in these uncertain times. If you do the right

research, it’s possible to find bonds that offer long-term returns

with lower risk than higher-yielding investment options.

Getting a better understanding on how bonds work gives

investors another avenue to access attractive income and to

build a diversified investment plan.

This eBook will outline tips and traps involved when investing in

bonds and will help you take the right approach on your search

for great returns.

Yours sincerely,

Peter Switzer

Leading financial commentator and founder of the Switzer Group

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Rethinking income & diversification

Market volatility is now a normal part of investing.

Central bank actions, geopolitical risks and commodity

price swings continue to hit markets around the world.

At the same time, investors confront a low interest

rate world. The recent decision by the Reserve Bank

of Australia to cut rates another 25 basis points to the

now cash rate of 1.75% will only mean lower rates for

longer. Adding to this is the recent reduction in dividend

payments from the banks who have historically shown

growing dividend payments.

Against this background, it will be increasingly difficult

for investors to access investment options that offer

good consistent income.

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tapping into the world of bonds

Most investors think of term deposits as part of their

fixed-income allocation. However, with rates at all-time

lows, the average 3 year term deposit is now offering

less than 3% p.a. For shorter time periods the interest

income being offered is around 2% p.a. Once you

factor inflation into your return the real value of your

investment after the period of the term deposit will

be much less than the interest rate offered. Also you

can’t access your investment without penalties until

the term is up. What you really should be considering

are bond investments which give you flexibility to

invest and redeem your money frequently and are

aiming to achieve returns greater than term deposit

rates. Remember though, with higher expected returns

comes higher expected risk, therefore you need to look

for bonds that offer lower potential risks while still

offering good long-term income returns.

AVERAGE TERM DEPOSIT RATES & P.A.Source: www.Ratecity.com.au as at 4th May 2016

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It’s time investors re-think their fixed-income exposure.

Investing in bonds can provide investors with the

opportunity to access income without the risks that

comes with other high-yield investments.

A bond basically works like this. Investors lend money

to a government or company at an agreed interest

rate for a certain period. In return, the borrower, the

government or corporate, agrees to pay the lender

interest at regular intervals and repay their loan at the

end of the term.

This means that bonds pay regular income payments

and most have redeemable dates, which ensures your

investment is paid back in full.

Bonds can pay floating, fixed or inflation-adjusted

income, usually on a monthly, quarterly or semi-annual

time period.

Let’s look at bonds in further detail.

Each bond is assigned a credit risk, i.e. the risk the

bond is not able to pay income and/or pay the initial

investment amount at the end of its term.

For example, NSW government issued bonds have the

best possible credit rating - AAA. This is because the

bond is backed by a government (we are not talking

about the Greek government here!). Then of course,

it is worthwhile to consider other classes of bonds

that may not be rated AAA but offer higher returns.

The following graph illustrates the Australian and US

government bonds against AAA, BBB and BB rated

bonds issued by corporations.

AAA TO BB SOVERIEGN & CORPORATE YIELD CURVESSource: Bloomberg

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The above chart shows how a bond with a lower

credit rating, e.g. BB, has a higher expected return

no matter what the term in years. However as we

have stated, this also comes with higher expected

risk expectations. AAA rated sovereign bonds, which

are basically federal or state government bonds, offer

the lowest expected return and also have the lowest

expected risk of default.

The AAA rating implies there is an extremely low

probability income payments will not be made or the

principal is paid at the end of the bonds term. At the

other end of the spectrum there could be a technology

start-up company issuing bonds and given the high

risk nature of the business the credit rating assigned

could be quite low, e.g. a B rating. Then, of course,

in the middle of the spectrum we have bonds issued

by all manner of businesses from medical through

utilities to food vending businesses. These are rated

BB.

Relative to the NSW government bond a B rated

technology company bond would be perceived as more

risky. So why would an investor buy the technology

company issued bond?

The income paid by this bond will be higher than the

NSW government bond. This higher yield is meant to

compensate the investor for taking on greater risk.

The below chart shows the expected return and risk for

each of the different types of credit ratings given by a

group such as Standard and Poors.

Investing in the highest credit rated bonds will give you

the lowest return relative to a Not Rated bond, however

the latter offers potentially much higher risk to your

initial investment and income payments. It should be

noted groups such as Standard & Poors don’t always

get their credit ratings right, hence why many bond

funds will invest in a broad spectrum on credit rated

bonds based on their own analysis of the potential

credit risk.

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The following chart sourced from JPMorgan shows

the default rate for High Yield Bonds (lower credit

rated and not rated bonds) and for Leveraged Loans

(secured loans to medium sized companies are called

Leveraged Loans in the US) in the United States over

the past 16 years. A payment default is the worst thing

that can happen to you when you buy a bond. That’s

why it is of paramount importance to understand and

examine all the cash flows of the borrower, to assess

and understand the credit risk attaching to a bond or a

loan before making an investment decision. Assessing

credit risk is a complex and difficult task that should

be performed by an expert.

This chart illustrates that from time to time default

rates rise and fall, times can get tough. This is why a

successful bond investor will always apply a worst case

stress test to every bond investment before making a

purchase decision. Only after applying the stress test

can an investor be confident of receiving back 100%

of a bonds principal and interest obligations, even in

the worst case economic scenario.

As the chart shows, defaults peaked for these two

bond types in around December 2009 at the height of

the GFC. It is during these events like December 2009

that you want to make sure the bond you have invested

in doesn’t default. Currently the defaults rates are

approximately 3.68% and 2.15% respectively.

Source: J.P. Morgan

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how are they traded?

The vast majority of bonds are not traded on the

Australian Securities Exchange (ASX) nor any global

stock exchange. They are traded on what is called the

“over the counter” market. This is a market where

bonds are traded directly between bond brokers,

fund managers and other bond intermediaries. Retail

investors can access some bonds however in large

dollar multiples and normally through a bond broker,

e.g. FIIG. Only recently have some bonds been made

available via the ASX.

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so, are bonds the same as hybrids?

Bonds are not the same as hybrids. As the name

implies, hybrids are an investment structure that

exhibits the features of both an equity and bond

investment. Recently, Australia has seen a number

of hybrids issued, in particular by the Australian

banks. While they offer potential good income returns,

because they are listed and can be traded on the

ASX their value is based on equity and bond market

conditions and the value of the underlying issuers, i.e.

the Australian bank that issued it.

While some of the hybrids available are offering very

attractive returns, the capital value of these hybrids

can fluctuate due to movement of the underlying

share price of the issuer. Using Crown as an example,

when the Crown share price goes down, there is a

high probability the Crown hybrid will also move down

in value and vice versa. This is due to the potential

convertibility of the hybrid to a share so it makes

sense its value would be affected by movements in

the underlying share price. The chart below shows the

historical price relationship between the shares and

hybrids issued by Crown.

CROWN SHARE PRICE VS HYBRID PRICESource: Bloomberg

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what are the risks associated with investing in bonds?

Like any investment there are risks. Investors need

to consider three main risks when investing in bonds

which are credit, market and liquidity risks.

Credit RiskAs highlighted earlier in the report, credit risks are

the risk income payments will not be made and the

issuer of the bond will default and the investor could

potentially lose all their investment. Bonds are usually

given a credit rating by groups such as Standard and

Poors and/or Moodys. These groups provide a scale

which goes from AAA rated bonds, i.e. the lowest credit

risk, to Not Rated meaning the highest possible credit

risk.

Market RiskAs the name suggests, market risk is based on the

overall investment market activity, e.g. how the recent

global uncertainty about economic growth impacts

the pricing of investments such as bonds. This means

when bonds are valued each day they will reflect the

investment market uncertainty, so if an investor was to

sell a bond during periods of high investment market

uncertainty there is a high probability they will get a

lower price than if they sold when conditions were less

uncertain. This risk also applies to the equity markets.

Liquidity RiskThis risk is tied to market risk in that during high

periods of uncertainty, like we experienced during the

global financial crisis, they may be less buyers than

sellers of investments which means firstly, it could

take longer to sell an investment, and secondly, the

selling price could be much lower due to there being

less buyers. This risk also applies to equity markets,

in particular, the smaller and micro-cap stocks that

aren’t usually traded that much in normal market

conditions.

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mitigating the risks

this doesn’t mean just investing in the best credit rated

bonds such as government bonds. There are thousands

of bonds issued every year that offer different credit

ratings and different income payments. In some cases

a higher credit risk bond may be a better investment

than a lower credit risk one.

(i) Bond Selection:

(i i) Diversi f ication:

(iv) Volati l i ty Management:

( i i i) Outsourcing:

in the value of a managed bond investment fund

can be a good indicator of an investment manager’s

experience and success in selecting bond investments

with a reliable Return to Risk ratio. If a bond fund

manager is able to produce relatively high returns

over a long period of time (say 5 to 10 years) with

low volatility in those returns then this indicates the

manager knows the market and has been selecting

the best bond investments to control risk and deliver a

stable return over time.

to experienced investment managers. Bond investment

requires a detailed knowledge of the mechanics behind

their pricing and how credit risk is determined. This

comes with extensive practical market experience.

Experience also helps in cross checking the credit risk

rating the credit rating groups give, as in many cases,

the rating is not truly reflective of the bond. This was

particularly highlighted during the global financial

crisis, which revealed that the credit rating groups were

wrong with their assessment of these bonds. Therefore

you need an experienced bond manager to make sure

the bonds will pay income and have a low probability

of not paying the principal investment back.

spreading your bond investments across a number of

bond issuers and sectors.

As we have stated, all investments come with some

sort of risk, however, these risks can be reduced

through careful;

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comparing income sources

Shares pay income, so why wouldn’t I just invest within

shares, or with a share fund manager?

This is correct. Here in Australia, we have been fortunate

to have a tax system that favours the investor, i.e.

imputation credits. The Australian banks in particular

provided good income distributions over the years,

however there are many companies that don’t.

Australian companies paying good dividends have

played an important role in the portfolios of yield-

hungry investors. However, with the patchy growth

outlook, many of these companies will struggle

to boost earnings, which will affect their ability to

maintain their dividends. While BHP Billiton was not

considered an income stock, its decision to cut its

dividend in over 30 years served to highlight that this

may be a reality for many companies.

It’s important to note that shares, like bonds, are

exposed to both market and liquidity risk in times of

uncertainty.

As an investor, selection, diversification and the

outsourcing to an experienced investment manager

are important to minimise these risks.

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why then invest in bonds?

Look at the chart below. Remember that not all shares

pay the income levels banks and Telstra do and that

bonds only pay income.

We can look at the period from mid 2004 to late 2007

as an example. The share index during this period rose

rapidly while the bond index had a steady rise. Now look

at the period from late 2007 to early 2009, a massive

fall in the share index occurred. To the present day

the share index has risen again while the bond index

continued its steady rise. Noting as well the numbers

are based on indexes that are made up of hundreds of

shares and bonds, so if you were able to pull out only

the best performing shares and bonds the outcome

would be very different, however, if you were able to do

that you wouldn’t be reading this eBook, you would be

retired on a beach in the Caribbean!

Having an investment portfolio that contains both

shares and bonds would be a prudent investment

decision. As the chart below shows, while shares and

bonds can perform the same during periods of extreme

investment market uncertainty they can perform very

differently during other periods. It is during these

periods where the true benefits of diversification are

achieved by holding both shares and bonds.

BLOOMBERG AUSTRALIAN MASTER BOND INDEX VS ASX S&P 200 INDEX

Source: Bloomberg

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what is the best way to invest in bonds?

There are two main ways to invest in bonds:

The direct approach

Managed fund

As mentioned above you could purchase individual

bonds via a bond broker/intermediary. If you have

sufficient investment funds you could purchase a

number of different bonds to gain diversification

however you may be limited to the sectors you could

access and therefore the potential income. You may

also end up with a country bias in your holdings, i.e.

Australia. Given the vast majority of bonds are issued

overseas this bias would not necessarily be a good

thing from a complete portfolio perspective.

However bear in mind that successfully selecting

a single bond investment requires a high level of

knowledge and market experience. Prices on single

securities can differ in over the counter markets from

buyer to buyer and no two bonds are the same.

Investors can access an experienced bond investment

manager who will have a portfolio of bonds diversified

across the credit risk spectrum, by sector and by

country. The bond investment manager will manage

this fund daily and some funds will focus on just the

highest credit rated bonds, others the lowest and some

funds across the whole spectrum. Each therefore will

have different income and return objectives.

Given the benefits that can be received from aggregated

buying power and specialist experience, a good bond

fund manager will usually deliver returns net of fees

that are not achievable by individual investors investing

directly.

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CONCLUSION

With interest rates set to stay lower for longer and

a benign growth outlook, it will challenge investors

to rethink their approach to where they can source

income. While equities will always play an important

role in an investor’s portfolio, it’s time investors look to

diversify their sources of income beyond term deposits

and income stocks such as banks and Telstra. Bonds

offer investors sustainable sources of income but also

the ability to achieve a truly diversified portfolio.

D I S C L A I M E R

Whilst the information and statistics contained in this article are believed to be correct at the time of publishing, they are indicative only and do not constitute legal or financial advice. Investors should seek independent financial and legal advice before deciding whether any

investment is right for them.