INSIGHT

Fixed Income and the hunt for yield Insight Citibank

November 2016

Fixed income and the hunt for yield

In a low growth, low interest rate global environment, the search for yield is a growing challenge for investors according to Citi analysts – especially with volatile global equity markets reacting to political and economic uncertainty.

Meanwhile, Citi also expects cash rates to remain lower for longer as central banks struggle to tackle low inflation and lack of growth, providing cash investors with minimal returns.

"In Australia, the RBA has cut the official cash rate to an all-time low and we expect another rate cut by the end of the year if local inflation undershoots," comments Citibank Investment Strategist Simson Sanaphay.

Despite this, we’ve observed solid returns in investment grade bonds.

"In the first half of 2016, equity market performance was mixed – but gains from US investment grade bonds ranged upwards of 9% between August 2015 and August 2016," he says.

As a defensive asset class, bonds can produce recurring income and provide stability through market ups and downs. So what role could bonds and other fixed income investments play in your portfolio?

Understanding bonds

Companies or governments issue bonds to raise capital, making them another form of debt. When you purchase a bond, the issuer pays you regular interest and will also repay the face value of the bond when it matures.

"While shares may give you a proportion of company profit, via dividends, there is always the risk those dividends will be eroded by reduced profitability," Sanaphay says. "However, bonds are legally binding contracts. The borrower must pay you a return, in the form of semi-annual or annual coupons through the life of the bond, as well as the face value of the bond value when it matures."

While bonds are slightly more risky than a cash deposit, they typically offer higher returns. "Different borrowers have different credit strength," explains Sanaphay.

"Recently, blue-chip companies such as Apple have been able to offer 'Kangaroo bonds' (corporate bonds on the Australian market) at relatively tighter spreads given their strong financial stature and investor demand."

Income certainty

Interest is typically paid every six months, providing dependable cash flow and the opportunity to compound your returns.

Most bonds are issued as fixed rate bonds, which pay the same interest through the life of the bond. When interest rates are low or falling, their face value may increase on the secondary market as they offer investors higher yield than the cash rate. However, the opposite is true if interest rates start to rise.

If you prefer to hedge the risk of interest rates or inflation rising, you can also invest in floating rate bonds (linked to the bank bill swap rate, or BBSW) or inflation linked bonds.

"In the first half of 2016, equity market performance was mixed – but gains from US investment grade bonds ranged upwards of 9% between August 2015 and August 2016." Simson Sanaphay.

Dividends vs coupons

While dividend yields are still higher than government bonds in most major developed economies, dividends are never guaranteed.

"In terms of investment income, a blue chip stock like BHP may slash its dividends if profit performance is below expectations. But bondholders with BHP would still continue to receive their coupons at the same rate." explains Sanaphay.

That’s why bonds can help you smooth out the income impact of equity market volatility on your investment portfolio. As this graph shows, the total annualised returns for Bloomberg AUD investment grade bonds was higher than the S&P/ASX 200 Index between 2010 and 2016.

Investment grade bond index vs ASX200 Total return Index 2010-16 - Citibank

 Comparison between bond and equity indexes - Citibank

Capital stability

Bonds are classed as senior secured or unsecured debt, or subordinated debt, which places them high in a bank capital structure. This means bond investors are prioritised over equity or hybrid investors if the issuer becomes insolvent.

Senior secured debt carries the least risk – even less than a term deposit – as these investors will be repaid first in the event of liquidation. "Bond investors are compensated for an increasing risk of default in the form of higher coupons," explains Sanaphay.

Diversify your investments

There are hundreds of different bond categories available on the global market – and you can choose bonds in local corporations, or global enterprises not available on the ASX, such as Apple, Intel and Coca Cola. Bonds also allow you to invest in long-term income producing infrastructure (such as airports), universities and governments.

You can also stagger your bond maturity dates to provide capital at known dates, making it easier to plan future investments.

"As well as yield, there are so many variations in the types of bonds you can choose from. Step-up bonds, for example, offer additional features for investors who want to be rewarded for the potential downgrade risk of an investment grade bond," says Sanaphay.

Investment liquidity

Unlike term deposits, you can also trade your bonds before maturity. If your bond face value rises due to changes in interest rates or issuer performance, there is a strong secondary market ready to buy.

"When investing in bonds, you need to look for transparent pricing and liquidity. With Citi's global footprint, we're able to deal through multiple counterparties and price contributors around the world so we have access to a broad range of buyers and sellers," comments Sanaphay.

Likewise, you may be able to purchase bonds at a discount (below the first issue price) on the secondary market and hold them to maturity, realising a small capital gain in the process.

How much should you hold in bonds?

According to Jim Bogle, founder of Vanguard investments, the rule of thumb is to hold "roughly your age in bonds." As you get closer to retirement, you have less time to make up any unexpected capital losses – and you become more concerned with creating regular, stable income.

"Our asset allocation model doesn’t stipulate specific proportions for fixed income," says Sanaphay. "It depends on the market situation, and the current value and opportunities we see in the bond market at any time. Each client needs to feel comfortable with their portfolio’s level of risk and return."

Citi analysts currently believe longer duration investment grade corporate bonds are relatively attractive, and they have a quality bias on high yield bonds.

If you’re seeking predictable income and greater confidence that your capital will be preserved, bonds are an essential part of your portfolio. However, bear in mind you’ll need to be a wholesale investor (with an annual income of over $250,000 or net assets in excess of $2.5 million as certified by your accountant) to invest directly in bonds.

And of course, like any investment, it’s important to actively manage your bond allocations and keep an eye on market conditions.

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