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The volatility neutraliser

Allocations to fixed income have long been considered a safe haven from market volatility, but Chris Black says knowing the right type of bonds to invest in is a key factor.

It has been well documented and often quoted that Australians are underweight fixed income assets. In fact, research in 2012 from the Organisation for Economic Co-operation and Development and Rice Warner indicated large Australian super funds allocated a little more than 10 per cent to this asset class and SMSFs had just 1 per cent allocated to Australian fixed income.

This is considerably less than the global average fixed income allocation of just over 50 per cent. Yet Australia has an ageing population, which suggests portfolios should be more conservatively constructed and income focused.

Although general planning principles would suggest the current allocation to fixed income assets is inappropriate for older investors, it is widely accepted SMSF investors have historically, and still tend to, avoid fixed income in favour of property and equities. But why do they do this?

Many Australian stocks do provide reasonable dividend yields and the growth in the domestic property market has benefited the real estate investment trust sector. There is also possibly the familiarity factor, whereby investors believe they understand equities and property better than fixed income.

This lack of solid diversification in SMSF portfolios and, in particular, the fixed income allocation is a concern and means investors broadly are more exposed to risk than they may be aware of or have the appetite for.

There are investment opportunities in the fixed income market that can reduce an investor’s risk and may even help immunise investors from future market volatility. Yet not all fixed income assets provide the same benefits. It is a matter of understanding the differences. Reflecting on recent market history may provide some context.

The key concern of global risk markets in the past couple of years has been the timing of the United States Federal Reserve (the Fed) raising interest rates. Once the Fed raises the cash rate, it is likely to be a catalyst for significant volatility in the markets.

In May 2013, when the Fed first announced it would start to taper its quantitative easing program, global equity markets sold off. The Australian stock market dropped more than 10 per cent in a month as a result of the news.

While markets later stabilised, after the Fed provided reassurance that rates would stay low for a considerable period, the initial reaction is a harbinger of how markets are likely to play out when the Fed inevitably decides to raise rates.

However, at the same time that the equity markets took a hit in May 2013, the government bond market also sold off quite dramatically. Australian government bonds, for instance, that had 10 years until maturity lost about 7 per cent between May and June 2013.

The example certainly begs the questions why did government bonds sell off so dramatically if fixed income is less risky and will an allocation to fixed income immunise investors from volatility in the future?

Interest rate risk versus credit risk

There are two distinctly different types of exposure within the fixed income markets: interest rate risk and credit exposure.

Bonds with interest rate risk may not provide investors with the hedge against volatility they have done in the past. In contrast, bonds with credit risk should deliver greater returns than term deposits and still allow investors to avoid sell-offs in the market when they arise.

The difficulty for investors is that the bond market is generally not widely understood or explained, and investors should also understand the important distinction between interest rate and credit risk. Both can influence the returns investors ultimately receive.

To explain, an Australian government bond with a fixed coupon to maturity only has interest rate risk. So, if the broad level of interest rates rises, the price of that bond will fall. This is because newly issued government bonds will have a higher coupon rate, and so make the older bonds less attractive.

Interest rates have been falling for more than three decades. The yield on the 10-year government bond hit a high of 16.4 per cent in 1982 and is currently around historically low levels at 3.3 per cent. With yields driving lower, the price of previously issued government bonds has been going up.

Traditionally, bonds with interest rate risk have been regarded as a good hedge for an equity portfolio. That is because while poor economic news may put downward pressure on equity prices as it suggests a slower economy and weaker corporate earnings, it has in the past put upward pressure on bond prices because it implies the Reserve Bank of Australia (RBA) will lower the cash rate to support a weaker economy. As mentioned above, bond prices are inversely related to bond yields.

Currently, this traditional paradigm appears to be broken. Although interest rates are at their lowest levels in decades and the inflation outlook is currently benign, the consensus view is that when inflation inevitably arrives, the RBA will address the risk by swiftly increasing rates. This will have a significant negative impact on equity valuations. And while bonds with interest rate risk have historically been part of the cure, interest rates going higher are likely to be a major cause of volatility going forward.

In this new environment, investors should focus on adding bonds with credit risk to their portfolio.

To illustrate an example of credit risk, take a BHP Billiton five-year corporate bond that pays a floating rate of interest (as opposed to a fixed rate). The price of this bond will not change if the broad level of interest rates increases because the future coupons of this security are also expected to increase.

Rather, the price of the bond is susceptible to the value the market assigns to BHP’s credit risk. If news and views about BHP are negative, then the market may assign greater credit risk. This will then translate into a lower price for the BHP floating rate note as investors will demand a higher rate of return. The BHP floating rate note has credit risk, but has little interest rate risk.

Risks explained and worth considering

Risk is generally defined in the financial world as an asset or portfolio’s volatility of returns.

The BHP floating rate bond may fall as a result of negative news on the company, but the impact will be more muted than on the value of BHP equities. The risk associated with the BHP floating rate note versus BHP equities is highlighted by the relative moves in the two assets over recent time. As the dividend yield on BHP equities is equivalent to the coupon on the BHP floating rate note, the risk comparison is to the price movements of the two assets and this has been dramatic.

Between the start of August 2014 and mid-October 2014, the price of BHP equities was down more than 15 per cent, whereas the BHP floating rate note has been down no more than 0.5 per cent in the same period.

Fundamentally, fixed income assets such as the BHP floating rate note are less risky because they have a fixed maturity date and rank higher in the capital structure than equities.

For most companies their capital structure is fairly vanilla, consisting of equity at the bottom with subordinated and senior debt ranking respectively higher in the event of a default.

The capital structure of a bank is a little more complex. It has tier 1 debt that ranks above equity but below subordinated debt and contains equity-like features. A bank like Commonwealth Bank of Australia (CBA) has issued tier 1 debt, subordinated debt and senior debt into the public markets.

SMSF investors can access bonds with credit risk, but not interest rate risk, through the Australian Securities Exchange (ASX). In fact, the majority of the ASX-listed bonds are floating rate notes, so are not exposed to interest rate risk. The CBA Perls VII, which are widely held by retail investors, are a prime example. Being CBA tier 1 securities, these notes have credit risk, but because they pay a floating rate of interest, no interest rate risk.

The difficulty for investors is knowing the risk they are assuming and the price they should pay for that risk. For instance, CBA Perls are quite complex bonds and have equity-like features that investors need to understand before they invest.

As a result of their deeply subordinated status in CBA’s capital structure, the credit risk attached to CBA Perls is greater than the CBA subordinated debt bond, which in turn is greater than senior debt credit risk.

While the institutional market gets insights into where credit risk should be priced, this information isn’t readily available to retail investors.

There are further considerations. While ASX-listed fixed income securities are easily accessible for retail investors, the range of issuers is limited. Listed fixed income credit represents only 8 per cent of the total market for fixed income credit assets within Australia.

Further, the majority are subordinated in the capital structure and, like the CBA Perls, may include equity-like features. As this market is dominated by retail investors who don’t get clarity as to where credit risk should be priced, this can result in ASX-listed securities trading at a significant discount or premium compared to the more efficient unlisted market.

The alternative avenue for investing in fixed income securities is through the unlisted market, however, direct access is only open to sophisticated investors as defined under the Corporations Act. Most unlisted corporate issues have a minimum tradable parcel of $500,000, so while some brokers look to break these down into smaller denominations, holding a non-marketable parcel can add to illiquidity issues in times of heightened volatility.

The larger minimum denominations also make creating an appropriately diversified portfolio difficult for small to mid-size investors.

So while SMSF investors should be looking to increase their exposure to fixed income credit markets, for the reasons stated at the beginning, the set-up in Australia for direct investment does make this difficult.

Managed funds, such as the Laminar Credit Opportunities Fund, help address many of these issues and provide investors with access to the wholesale fixed income market through the fund.

The added benefits are that these funds can provide greater diversification at a lower minimum investment amount with access to bespoke opportunities that would otherwise be unavailable to retail investors.

So, to summarise, the low cash rates set by reserve banks worldwide have created a surplus of easy money that is slushing around in the global financial system. In recent years, this has led to a rise globally in the prices of riskier assets. However, it is yet to translate into higher levels of inflation. This will inevitably occur. When it does, interest rates will rise and we expect there will be a sell-off in both the equity and the Australian government bond markets that will dwarf the drop seen in May 2013.

Given Australia’s ageing population, domestic portfolio construction should increasingly have a bias to conservative assets, that is, a reduced allocation to equities with a corresponding increase in exposure to fixed income. But it is not a simple switch. Investors need to understand there are differences between bonds that have interest rate risk and credit exposure and how to access the breadth of opportunities in the fixed income market.

A portfolio that has an allocation to bonds with only credit exposure should outperform when the markets become volatile. And while the ASX provides access to fixed income credit bonds, there are complexities and limitations to this market.

It would be prudent for SMSF investors to be looking for a specialist fixed income fund manager that fully understands the market and can source the best fixed income credit bond opportunities from the offers available.

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