Citi's guide to bond investing
Why consider offshore bonds?
By Citi fixed income specialist Elsa Ouattara
While rarely mentioned in mainstream finance commentary, offshore bonds offer much needed diversity for investors in a well rounded portfolio, as well as a way to enhance returns in the current low interest rate climate.
As with a standard term deposit, bonds offer access to predictable cash flows by way of regular ‘coupon’, or interest, payments. But they also offer the potential for capital gains if the value of the bond increases, as well as the ability to protect real purchasing power with returns that exceed the inflation rate.
Unless the bond issuer defaults, investors know they will get the face value of the bond at maturity.
While bonds are acknowledged as a prime avenue for capital preservation they can also be a growth asset and are not correlated to stock market movements.
But bonds can also be a growth asset, as they fluctuate in value on the secondary market and are worth more than (or sometimes less than) face value at any point in time. Bonds with longer maturity dates usually have higher attached yields because of the additional risk that more time adds for the bondholder.
Typically, bonds are issued by companies, governments or public bodies as an alternative to bank funding.
How offshore bonds fit into a broader asset allocation?
"Like building a house on solid foundations, asset allocation is the most crucial determinant of how an investor’s portfolio will perform over the long term."
Like building a house on solid foundations, asset allocation is the most crucial determinant of how an investor’s portfolio will perform in the long term.
As its name suggests, asset allocation is the proportion of funds placed into various asset classes, taking into account the investor’s risk appetite, personal situation and long-term goals.
With a strong bias to local equities, too many Australians are building their ‘house’ on shifting sands, rather than concrete. Remember that in the short term a bias to one asset may reap rewards, such as property in recent years.
But rather like the hare and the tortoise, the carefully weighted portfolio is likely to win in the long term. Or at the very least, well-designed asset allocation can protect a portfolio against cyclical volatility.
What types of assets could be considered in a portfolio?
On the growth side, assets include international and domestic equities, commodities and property. On the income side fixed interest, cash and bonds are common examples.
International bonds are both a source of income and potential capital gains, as well as a way for investors to achieve geographic and sectoral diversity (given they are usually overweight in domestic financial equities).
An important consideration is that asset allocation is a dynamic process, rather than a ‘set and forget’ one. That’s because the original allocation split will become skewed as the better performing asset class accounts for more of the portfolio than originally intended.
While it’s tempting to stick with a winner, assets will perform differently over time. Yesterday’s winners are unlikely to be tomorrow’s winners, so there’s a case for taking profits and restoring the originally intended asset split.
Investors’ asset allocation may also need to be adjusted over time to suit different stages of their life. As a general rule, as you get older your portfolio will become more risk averse to protect the wealth that compound interest and smart investing generates.
A well-constructed portfolio initiated by asset allocation will help avoid mistakes or rash decisions, and will always aim towards long term goals rather than short term hunches.
The benefits of bonds
"As a diversification tool, bonds offer the potential for performance when equity markets are stressed and are an opportunity to spread risk across varied geographies and industries."
The importance of diversity
Bonds are an especially relevant consideration for Australian investors who have stuck to the comfort of local shares, especially the dividend-paying blue chip stocks dominated by the banks.
As a result, a typical investor’s portfolio lacks diversity across both asset types and geographies and is vulnerable to value erosion when the share market enters one of its regular downward cycles.
According to the 2017 ASX Australian Investor study, 40 per cent of investors say they do not have diversified portfolio, holding an average 1.6 investment products. Furthermore 46 per cent claim to be diversified but still only hold 2.7 investment products.
A further 15 per cent don’t know if they are diversified or not!
The concentration is exacerbated because of the limited diversity of the share market: of the S&P/ASX 200 stocks, the financials (mainly the banks) account for about 40 per cent and resources (BHP, Rio Tinto and Woodside Petroleum) account for around one-quarter.
As a diversification tool, bonds offer the potential for performance when equity markets are stressed and are an opportunity to spread risk across varied geographies and industries (offshore equities also do this, but don’t offer the product diversification).
Bonds for income
"Low returns on term deposits mean cash may not be preserving investors’ capital, with the ‘safe’ investment eroding in value in real terms."
For yield hungry investors, corporate bonds are preferable to shares in terms of receiving regular predictable income, given that a company’s dividend policy can change according to earnings and economic circumstances.
Bonds offer higher returns at a time when domestic bank term deposits rates remain stubbornly low. As of mid November 2018, one year deposits averaged 2.2 per cent, while even investors locking away their funds for ten years could expect no more than 2.67 per cent on average.
The Reserve Bank of Australia has maintained the cash rate at a record low of 1.5 per cent since August 2016. With most economic commentators expecting the central bank to move later rather than sooner, term deposit returns don’t look like increasing in a hurry.
A key benefit of bank term deposits is that the government guarantees balances up to $250,000. Failing a catastrophic economic collapse, term depositors will get their money back and the same can’t quite be said for corporate bonds.
But there’s another risk for term depositors, in that their interest payments are not even keeping up with their purchasing power. Such low returns means that cash may not be preserving investors’ capital, with the ‘safe’ investment eroding in value in real terms. What’s more, the average term deposit rates of Australian banks has decreased by more than 50 per cent over the last ten years, from 5.25 per cent to 1.95 per cent.
This is where a carefully selected portfolio of overseas bonds can enhance returns while injecting some geographic diversity. As a guide, investment grade bonds rank just behind cash at the ‘low risk, low return’ end. Property usually ranks as medium risk and return, while shares (both local and international) rate in the high risk, high return end.
Bonds as a defensive investment
The recent turmoil on global stock markets has highlighted the crucial role that bonds play in a well-balanced portfolio. The age-old rule of thumb is that when shares underperform, bonds outperform.
In October, the local share market fell 6 per cent while $A-denominated bond valuations were steady.
During the global financial crisis, the share market swelled 53.7 per cent (between 2007 and 2009) while bonds gained 15.6 per cent. Similarly, when equities declined by 20.2 per cent between April 2015 and February 2016, bonds gained 2.6 per cent.
"Bonds act as a shelter in times of stress and that has been proven recently," says Citi fixed income strategist Elsa Ouattara. "As a result, investors increasingly considering bonds as part of a well-balanced portfolio."
By their nature, bonds offer fixed income – a valuable attributable for yield-dependent investors in retirement phase.
But they also offer risk mitigation via diversification, not just into a different asset class but across geographies and industries. "Diversification is very important for investors in building a portfolio and navigating markets to reach their long-term goals," Ouattara says. "Diversification ensures that if an investment doesn’t deliver to expectations, there’s a lesser impact on their total portfolio."
Bond diversification is achieved by investors holding paper from geographically diverse issuers with varying duration (to manage the volatility of the rates market). “There’s diversification at geographical level and also diversity across the (rates) curve,” Ouattara says. “So investors are currently bundling their (bond) investments with floating rate notes to lower the interest rate risk of their portfolio.”
What influences bond prices?
Bond prices are affected not just by interest rate expectations, but a range of other factors as well. These include:
Supply and demand: When there are many issuances on offer, investors have more choice and as with any asset this will influence their willingness to pay and thus the issuer’s pricing of the offer.
Credit quality: Bonds fall in value if the creditworthiness of the issuer deteriorates, and rises when it improves. Companies do fail, although rarely those with a top-end investment rating.
Closeness to maturity date: Bonds tend to converge to their initial face value as the maturity date approaches, which is to be expected.
Pre-maturity trading: Bonds can be bought and sold before they mature at prices other than their face value, usually either in over-the-counter markets or trading exchanges. Investors can sell bonds at a profit or loss depending on market prices or trading exchanges.
Interest rates: Most bond prices fall with rising interest rates, and vice versa. Bonds with longer terms and a fixed coupon are more sensitive to interest rate movements.
Comparing offshore bonds
Corporate bonds come in several varieties and offer various levels of risk.
As their name implies, offshore bonds are issued by overseas issuers that fall into three categories: government, semi government and corporate/financials. These instruments are usually denominated in $US or Euros.
But there are an increasing number of Kangaroo bonds on issue- $A denominated issues from brand name multinationals such as Apple and, more recently, Verizon (the second biggest Kangaroo corporate deal after Apple at the time of issuance).
Just as bonds are issued by any number of entities, they don’t come in a one-size-fits-all structure. The most common, the fixed rate bond, pays a fixed interest rate (called a coupon) at regular intervals. Variants include zero coupon bonds, which pay no interest but are sold at a deep discount to their face value.
Most bonds are redeemable at face value at a set date, whether it is 30 days or 30 years. In the case of callable bonds, the issuer has the option of redeeming the bonds before maturity at a specific price.
Convertible bonds allow investors to convert the debt to the issuer’s shares at a predetermined price.
As with overseas shares, international bonds enable investors to expose themselves to sectors that are sparsely represented in Australia. Examples are the major tech companies such as Apple (currently the biggest company in the world by market capitalisation), government-owned banks and other leading blue-chip names.
What are Kangaroo bonds?
The so-called Kangaroo bond market – well-known foreign names issuing $A denominated paper to raise funds here – has been moving in leaps and bounds since Apple launched the first largest corporate Kangaroo deal in 2015 for $A 2.25 billion.
Since then a slew of companies has followed, including telco giant Verizon, the world’s biggest brewer Anheuser-Busch and several European banks. “The Kangaroo bond market has been taken to a higher level since 2017 as more companies come to issue on the Australian market,” Citi’s Ouattara says.
Ouattara says Kangaroo bonds have become popular with local investors, as they offer superior returns relative to the local banks’ popular high-quality paper.
At the same time, they eliminate currency risk.
“$A-denominated bonds have not been impacted as much by rates rising, as is the case with US bonds,” she says. “So they’re acting as a safe haven and pay attractive yields.”
As a rule of thumb, typically Kangaroo bonds offer up to 1-2 percentage points better than a high-rated domestic bank bond issuance.
“Our investors are looking to invest in bonds from well-known global corporates while receiving attractive yields,” she says.
Source: Citi Research, Forecast as of 18 July 2018
"The rule of thumb with any investment class is the higher the return, the greater the risk - and bonds are no different."
What are the risks?
The rule of thumb with any investment class is the higher the return, the greater the risk - and bonds are no different.
However many investors do not realise that bonds are inherently safer than shares because they rank higher in the creditor ‘queue’ if the entity issuing the paper fails.
Failing corporate default, investors can expect the face value of the bond to be repaid on maturity, no matter what the paper trades for on secondary markets.
Just as no such thing as a free lunch, risk-free high yielding investments don’t exist.
For a start, bondholders have no control over market risk: bond prices fluctuate as a result of changes in interest rates and the inflation outlook. Generally, when interest rates fall and inflation will fall, bond prices will rise.
But when interest rate expectations are rising – as is the case at present – bond prices likely will fall.
Market sensitivity varies according to the duration of the bond: there’s more chance of things going for a bond over a five year life than a two year life.
Credit risk means bond holders can lose their money if the issuing company fails. Naturally, the risks are higher with a company with a poor credit rating. In some cases, a company might survive but suspend coupon payments for a period to preserve cash.
While less of a risk in western countries, political upheavals or changes to government policy can affect the value of a corporate bond if the issuer is seen to be disadvantaged.
The importance of credit quality
When it comes to risks and rewards, no bonds are the same. Influences include the financial strength of the issuer (as reflected in the credit rating), perceived sovereign risk and factors affecting a particular industry.
Most of the bonds issued by western governments are rated the highest ‘prime’ or ‘excellent’ grades.
In the corporate sphere, investment grade bonds are rated as BBB- or higher, while those rated BB or below are classed as ‘speculative’.
Of course the lower the credit rating the higher the coupon return as the investor needs to be compensated for the additional risk.
In the event of a company going broke, bondholders are in a superior position to equity holders or holders of hybrid securities (a composite of equity and debt). Under the ‘debt hierarchy’, term depositors (if applicable) have priority right to be repaid, followed by senior debt holders (bondholders) and then subordinated holders.
Shareholders rank last in the credit queue and usually find their shares are worthless. Some companies are not rated at all, but they are not necessarily bad credit risks. For cost or other reasons, they have not asked for a rating from one or both of the key credit agencies.
Examples of bonds on offer through Citi
Citi offers a range of $US and $A denominated bonds, issued by both established global banks and investment grade corporates.
Examples of investment grade $US issuances include fixed coupon offerings from ING Group, Bank of America, Citigroup, Standard Chartered and HSBC Holdings. These bonds currently trade on yields to maturity of between 4.6 per cent and 4.8 per cent.
Non-bank issuers include French utility Electricite de France and the finance arm of the state-owned Singaporean investment company Temasek.
Dell’s issue maturing in 2026 trades on a yield to maturity (August 2028) of 5.1 per cent.
Rated AAA by Moody’s and Aaa by Standard & Poor’s, Temasek Financial’s $US1.35bn issue is priced on a yield to maturity (in August 2028) of 3.8 per cent.
$A denominated Kangaroo bonds include paper from British banks Barclays PLC and Lloyds and Spain’s Banco Santander and the large German regional bank Landesbank Baden-Wurttemberg.
Current yields to maturity average 4.2 per cent and range from 3.1 per cent to 5.2 per cent.
French bank BNP Paribas has issued paper maturing in October 2033 and callable in 2028, with a yield to maturity of 4.9 per cent (rated BBB+ by Standard & Poor's and Baa2 by Moody's).
US telco AT&T has three fixed-coupon $A-denominated instruments on offer, yielding 3.4 per cent to 4.6 per cent (lower medium investment grade).
AT&T also has a $A-denominated floating rate note (September 2023 maturity) priced at the 90 day bank bill swap rate plus 125 basis points (current return 3.1 per cent).
Coupon: the rate of interest payable to the bondholder, expressed as a percentage of the face value of the bond. Usually a coupon is paid quarterly, half-yearly or annually. In some cases, the coupon is a fixed rate. In others it is ‘floating’, fixed at a margin above a benchmark rate such as the bank bill swap rate.
Running yield: the expected annual income over 12 months, based on the price paid for the bond on the secondary market. If the bond is bought below face value, the yield will be higher than the stated coupon because a gain can be expected on the capital.
Yield to maturity: the interest payment plus the capital gain or loss on the bond, based on the current market price and assuming the bond is held to maturity.
Face/par value issue price: bonds are issued at a face value and that is the price at which they redeemable at maturity, normally $100. Face value can also be called par value. However, on the secondary market bonds can trade at a premium or discount at any time up to maturity.
Issue price: the price at which the bond was originally issued.
Maturity date: the date on which the bond matures and the issuer pays the bondholder the face value of the bond. Generally the longer the maturity, the greater the risk to the bondholder and the higher the interest rate to compensate.
Credit rating: an assessment of how well positioned the bond issuer is to honour coupon payments and redemption of the bond at maturity.
Credit quality is assessed by one or all of three international ratings agencies: Standard & Poor's, Moody’s or Fitch.
Bonds with a high credit quality are known as investment grade, while those issued by companies with low financial strength are known as high yield bonds.
Citi can help
Citi offers access to 1800 bonds across more than 500 issuers globally, across ten currencies and 50 industry sectors. These include 460 US-based offerings, 388 across Europe and 651 across Asia. At Citi, wholesale investors can invest in bonds with a minimum investment amount of $50,000.
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