With the stockmarket down 40 per cent, the humble bond has made a comeback. After all, commonwealth (federal) government bonds are the ultimate risk-free asset, against which all other investment returns are compared.
This is because no less an entity than the Australian government guarantees to pay the holder of that bond the interest payment on the due dates and the amount of the bond in full on maturity. A government bond is “sovereign” debt. In the Australian market, you cannot lend money to a better or more reliable debtor, which is why government bonds are rated AAA.
But there is a catch: a government bond is only risk-free if you know that you will hold it to maturity. If for some reason you need to sell it, you could make a capital loss, depending on where interest rates have moved in the meantime. If they have fallen, your bond will be worth more on the market.
“That is the main risk with bonds: interest rate risk,” says Steven Wright, director of fixed interest at ABN AMRO Morgans. “Investors have to understand that even though they’ve got a bond on which the coupons are guaranteed to be paid, and which will be repaid in full at maturity, if interest rates rise while they are holding that security and they choose to sell it, they may make a capital loss.”
The fact that bonds are traded – and the yield changes with every quote – can confuse some investors, says Wright. “Say a client buys a bond that’s trading at a premium – say it’s $105 – because it was issued at a higher coupon rate than new bonds. The investor needs to understand that at maturity, they’re not going to get $105 back. They will get $100 face value plus the last coupon. They have to understand what price premiums and discounts mean, and how that relates to the value of the bond.”
Bonds are priced from the yield curve (the relation between the interest rate – or cost of borrowing – and the time to maturity of the debt). Normally, the yield curve is upwardly sloping, meaning that the longer the maturity, the higher the yield (the opposite situation is called an ‘inverse yield curve’). At present, the Australian market’s yield curve is positive, with a five-year commonwealth government bond trading at about 5.4 per cent and a ten-year bond trading at about 5.7 per cent.
Next along the yield curve from commonwealth government bonds – and thus, higher-risk – are semi-government bonds. “All state government bonds carry either AAA or AA+ credit ratings, making them relatively secure investments,” says Brad Newcombe, senior research analyst at FIIG Securities. “In the fixed-interest world, they’re a standout investment at the moment. As with government bonds, the yield curve is positive: investors are being rewarded for ‘going long the curve’ with semi-government debt – they can get returns of about 5.8 per cent in five-year semis, and 6.3 per cent in ten-year semis.”
The key to understanding these securities is that they are a defensive asset class, says George Boubouras, executive director and head of investment strategy at UBS Wealth Management. “Over the May to July period last year, equities looked very dangerous, and our clients were buying government and semi-government bonds on our recommendation. When the yields went from eight-year highs to 50-year lows, the capital values rose, so they were quite happy. That’s precisely what those kinds of assets are in a portfolio to do.”
Government and semi-government bonds can be bought in parcels (minimum investments) of $50,000, says Wright. “Buying bonds for retail clients is a relatively manual process. Because they’re not traded on a single exchange, we enter into the market and buy or sell on behalf of the client. We hold the securities in safe custody on behalf of the client, and process their coupon payments through the holding period.”
Finally, there are corporate bonds, issued by companies. Because companies cannot match Australia’s sovereign credit ratings or those of the states, these are higher-yielding again – and consequently riskier. “Investors can currently earn returns of close to 8 per cent by investing in the debt of highly-rated corporates such as Telstra,” says Newcombe.
“And for investors who aren’t scared of overseas names, AXA, Swiss Re and GE Capital also have bonds offering outstanding value and a high credit rating. However, the real value at the moment probably lies in beaten-up property bonds. Property is on the nose at the moment due to declining values and liquidity issues with the banks. However, most of the property companies have now deleveraged their balance sheets through significant equity raisings, vastly reducing the risk associated with them. The good news is that the bonds of these companies are all still offering exceptional yields, with returns of at least 8 per cent – and in some cases, significantly more than that – available on GPT, Mirvac and Stockland debt,” says Newcombe.
Boubouras says investment-grade corporate bonds are a key part of the firm’s strategy for clients. “If you’re the kind of investor who need certainty of income, you need more exposure to income-generating asset classes. We repeat this time and time again, if you’re heading toward retirement mode, then certainty of income is paramount; and that certainty of income can only be delivered through an exposure to bonds versus equities. The dividend is an unknown, whereas the coupon must be delivered – and it ranks ahead of the dividend and the equity.”
Corporate bonds is a wholesale market, where you usually need at least $500,000 to play, but Boubouras says the global corporate bond market can be accessible to retail investors. “Investors can buy some Origin Energy bonds, some Australia Post, some Coles, some Gandel, BHP, Rio Tinto, Woodside, in $US – hedge out the currency immediately and pick up an additional 1-1.25 per cent ‘carry’ – and in small parcels. We’re telling our clients that investment-grade corporate bonds are still the sweet spot – there are so many opportunities, because we all know that the banks and the corporates need funding, and you don’t have to go out into the riskier high-yield territory. For example, three months ago, investors were offered Rio Tinto bonds at 10.9 per cent a year for five years, although that has come back to about 7.5 per cent now. We were able to buy $10,000 or $25,000 parcels of that for our clients,” he says.
Fortunately for smaller investors, the long-moribund retail corporate bond market is undergoing something of a renaissance. “This is one of the few positives of the global financial crisis: that it has seen the reopening of the retail bond market,” says Newcombe.
The April issues of ASX-listed fixed-income securities by Tabcorp Holdings Limited and AMP Limited revived this market: they were considered the closest things to a genuine retail corporate bond that have been listed for a long time: true corporate ‘names’, investment-grade rated, but tradeable in retail volumes. Although both are five-year issues, there is an important difference: the Tabcorp Bonds are senior debt, whereas the AMP Notes, are subordinated notes, ranking behind AMP’s senior debt.
The Tabcorp Bonds, rated BBB+, were priced at 4.25 per cent above the 90-day bank bill rate, implying an initial interest rate of 7.4 per cent a year. The AMP Notes, rated A-, were priced at 4.75 per cent above the 90-day bank bill rate, implying an initial interest rate of 7.9 per cent a year.
Both bonds were keenly sought through the prospectus and this has continued in the secondary market since listing, which has lowered the yields on offer. At $108.50 on the ASX, the AMP Notes trade at an implied yield of 6.1 per cent, and at $106.55, the Tabcorp Bonds are yielding 5.6 per cent.
“The great thing about the revival of the listed bond market is that it allows investors who don’t have the $500,000 needed to access the institutional bond market to invest in the ASX-traded debt of highly-rated corporates,” says Newcombe. “We expected that there would be a slew of retail bonds issued to investors after these initial issues, but the market hasn’t taken off as anticipated. There have been few subsequent issues of such securities, although at least when they do come to market they are still offering solid returns,” says Newcombe.
“For example, recently, Brookfield Multiplex issued a three-year property bond secured over a low-risk new commercial building tenanted by the Australian Taxation Office. The bond offered a return of around 8 per cent. For the quality of the security involved, it is reasonably low-risk for that return.”
Wright says the retail bond market “could take off” if government bonds are traded on the ASX. “Once we have that, we can start to stgelop a real yield curve in listed securities. Just like the wholesale unlisted market, we’ll have a government bond yield curve, we might get a curve for AA-rated banks, AA-rated corporates, BBB-rated corporates, and over time, that market could stgelop into something quite serious, where investors will be able to make assessments of securities from good-quality companies. If they want to, they can go out into high-yield to the extent they choose, to build in a high-yield component to their portfolio,” he says.
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