SMSFundamentals | May 29 2018
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Why Do You Not Own Corporate Bonds?
Corporate bonds are highly suitable as a portfolio allocation for retirement investors and interest is growing, despite many Australians being unaware of their existence.
-Fixed income stream
-Increasingly more accessible
By Greg Peel
Deloitte Access Economics has surveyed more than 700 Australian high net-worth individuals (HNWI) – those holding $2m or more in investable assets – on the subject of Australian corporate bonds as an alternative investment. If you’re thinking “Well, that’s not me,” do not be discouraged. Corporate bond investment is becoming increasingly accessible to lower-wealth investors and the reasons for holding corporate bonds extend to all investors.
Let’s start with some numbers:
The value of the Australian corporate (as opposed to government) bond market is in excess of $1trn, equivalent to 70% of the Australian share market.
Only 47% of those bonds are owned by Australians, including companies, institutions and governments.
Less than 1% are owned by private investors.
Only 16% of HNWIs own corporate bonds.
86% of those bond holders have had a positive experience and 37% intend to invest more in the next 12 months.
15% of HNWIs not invested in bonds intend to do so in the next 12 months.
70% of non-investors cite insufficient understanding as their reason not to invest.
An ASX study found one third of all Australian investors are not even aware that bonds exist.
In the period 2006-2016, incorporating the GFC, the Australian share market averaged an annual pre-tax return of 4.3% and the global share market 5.5%. Australian cash deposits returned 3%, and Australian corporate bonds returned 6.1%.
What is a bond?
When a company first issues equity, the buyers of those shares are handing over their money to the company to do with it what the company may. In return, those investors are hoping that the value of the company, and thus the shares, will increase over time, and that at some point some capital will be returned, such as in the form of dividends.
Most investors buy their shares in the secondary market (ASX). This means they are handing over their money to a person who bought previously, but indirectly the principal is the same – the investor is beholden to what that company does with their money.
Shares do not come with a maturity date. To “cash in” an investor can only sell on the secondary market at the price on offer at the time (notwithstanding takeovers etc).
Whereas shares are equity, bonds are debt. A company issuing a bond is simply borrowing money. If you buy a bond, you are lending the company that money. Again, the company can do whatever it likes with that money, but as with any loan, that money must ultimately be paid back, with interest.
If you buy shares, the risk is that company goes out of business. The same is true for bonds. If you lend money to someone, there’s no guarantee you’ll get it back.
However, while a financial crisis such as that of 2008 can strip -50% or more off the value of your shareholding, even if that company is in no danger of actually going out of business, a bond investment will only not be repaid if that company does completely go out of business.
Bonds are therefore less risky on a year by year basis. If you invest $100 in a five year bond, you will get $100 back in five years. Interest will be paid annually at a pre-determined and fixed rate (the coupon). Coupon payments are a contractual obligation for the bond issuer. Dividends are paid on shares at the discretion of the company.
We need not look far in the Australian market to find a company that has disappointed shareholders by cutting what was once a solid and consistent dividend (Telstra). Or to find a company that pays a solid dividend but whose share price devaluation has more than wiped out that gain (the banks).
If you invest in a bond you will get your money back and you will receive annual fixed coupon payments, unless that company goes completely out of business in the interim.
Given there is no capital gain potential from holding a bond to its maturity, the value to the investor comes down to that fixed coupon yield. The average corporate bond yield is lower than the average dividend yield because a bond is less risky than a share. Corporate yields are nevertheless higher than those of government bonds, which are considered “risk free”, and higher than bank term deposits, which are risk free to the extent of the government’s guarantee but can only be fixed for short periods of time.
Thus on the reward scale, corporate bonds sit between cash and government bonds at the low end and shares at the high end. But they also sit in the middle on the risk scale.
Why Invest in a Bond?
This chart may go some way to answering that question:
The chart compares returns over the period 1999-2014 for Australian equities (green line), in the form of the All Ordinaries Accumulation Index (dividends included), and for Australian corporate bonds (blue line), in the form of the Bloomberg Ausbond composite index.
The first observation is that bond returns are far less volatile than equity returns, indeed almost a straight line through the middle of the wildly swinging stock market. The second observation is that when the bond line does fluctuate, it does so in the opposite direction to equities.
Note in particular 2003, the dip following the US tech wreck, 2009, the GFC, and 2011, when the eurozone was threatening to implode. In all cases bond returns rose when stock returns plunged.
Of course, the opposite is also true. Stocks outperformed during the China-driven commodities super-cycle of the noughties, pre-GFC, in the China fiscal stimulus-driven commodity surge of 2009, and the “dividend yield is king” rally from 2012 when Australia’s banks were handing out money like candy.
But consider that if you were set to cash in your super on retirement, the luck of your birth date could have had you sailing around the world in your own yacht from 2007, or stacking shelves at Coles from 2009. Assuming, that is, your super was overly reliant on the stock market. An investment in bonds would have performed counter to the wipe-out that was the GFC.
That is not to suggest an investor should put all their money in bonds. The risk is lower but so is the reward. A portfolio balanced with a mix of equity and bonds provides an investor-for-retirement with a built in volatility dampener, and capital preservation.
The Deloitte survey found clear reasons why those HNWIs who hold bonds as part of their portfolios do so. Some 75% believe bonds provide a reliable income stream and relatively good returns given the risk. As a fixed income asset, corporate bonds provide capital stability and regular income payments, while offering higher yields than government bonds or bank term deposits.
“Given these drivers, corporate bonds can be well-suited to the investment preferences of private investors transitioning to retirement,” suggests Deloitte. “Retirees rely on accessing a predictable and stable income stream from their investments, and have a lower tolerance for risk and volatility as they have less time to rebuild their savings in the event of large losses”.
Notably, the survey found that of those HNWIs holding bonds, the over-55s averaged 22% of their assets in bond holdings, compared to only 3-4% for younger age groups.
The Risk-Reward Mix
The following graph tables the average allocations to different asset classes in HNWI portfolios. The green line is a breakdown for those who do invest in corporate bonds, and the blue line for those who don’t.
What stands out is that those investors not holding bonds have about the same allocation to equities, a bit more in cash, and substantially more in investment property. It is hard to argue that the past decade has not been a winner for those getting into investment property.
But that was then and this is now.
The Australian housing market is cooling. Stricter regulations imposed by APRA have made it harder to get an investor loan and more expensive if you do, while interest-only loans have become taboo. And that’s before any further restrictions flow as a result of the bank Royal Commission.
One of the concerns HNWIs have, as revealed in the Deloitte survey, is the possibility of a large fall in house prices. Understandably so, based on the graph above. Although in order of greatest concerns, a property crash comes in sixth.
Number one concern is the low yields HNWIs are receiving on their cash investments, which is their second highest allocation as the graph above shows. Rhetoric from the RBA suggests this is not about to change anytime soon.
The second greatest concern is straightforward – volatility in equity markets.
There follows concern over government policy uncertainty, the possible default of risky companies, and a change in personal circumstances, such as actually moving into retirement.
Company default is understandably more of a concern for those HNWIs holding bonds, but also for those not holding bonds. There were plenty of “mums & dads” swept into the re-listings of the likes of Dick Smith and Myer, for example.
Government policy is a point to consider when thinking about bond investment. One comparative downside to bond investment is coupon payments attract full tax, unlike dividends, which can be up to 100% fully franked. Mind you, so does interest earned on term deposits. Property investors also enjoy a tax break through negative gearing.
One cannot dismiss either side of politics as having the potential to move the goal posts on superannuation and other policies when in government – they do it all the time. But a clear and present example of risk for retirement investors is Labor’s stated intention to scrap dividend franking credits refunded as cash, and to either do away with or at least restrict negative gearing.
Corporate bond investment has no such swords dangling overhead.
Such risks hark back to the list of statistics at the beginning of this article, noting 37% of HNWIs already holding bonds intend to buy more and 15% intend to buy their first bonds.
How Do I Invest in Bonds?
Outside a simple lack of investor understanding of bonds, a simple reason why corporate bond investment in Australia is so low is that it has to date been largely inaccessible for all but the “very” HNWIs.
In Australia, some 95% of Australian corporate bonds are issued almost entirely to wholesale investors, Deloitte notes, with subsequent trading conducted in the non-exchange, “over the counter” market (OTC). As trading on the OTC market typically occurs in large parcels, private investors have historically needed to be very wealthy in order to participate. Currently, households hold only a small share of outstanding corporate bonds in Australia, and self-managed superannuation funds have historically faced similar barriers to directly investing in corporate bonds, with only 1% of SMSF assets held in debt securities as of 2017.
There are only a handful of corporate bonds listed on the ASX. More popular on the ASX are fixed income-related exchange traded funds (ETF), which are designed to track particular baskets of bonds. These are readily accessible for investors wanting to trade in smaller value parcels.
However a bond ETF is not a bond, and does not necessarily offer the same features as a bond, such as a fixed maturity date, principal preservation or even certainty in yield, Deloitte warns.
Recent innovations in the corporate bond market are nevertheless facilitating more private investor and SMSF activity. In particular, fixed income investment service providers such as FIIG Securities* have opened up direct bond ownership to a larger number of individual investors in Australia, Deloitte highlights. These service providers can access the OTC market and buy corporate bonds in large parcels of $500,000 or more, and then sell these investments in smaller parcels, as little as $10,000, which can be more readily purchased by individuals.
*[FIIG Securities provides FNArena with a list of corporate bond issues and relevant price and yield data each week for publication.]
Another issue to consider is that of all the bonds on issue in Australia as at June 2017, representing over $1trn in value, around $540bn represented issues by banks, $460bn by other financial institutions and a more modest $255bn by non-financial sector corporates.
For banks and other financial institutions, bond issuance represents a primary source of borrowing above deposits.
It is yet another reason why Australians have shied away from bond investment. If you’re not already invested in bank shares, your term deposit will be with a bank and so will your property investment loan. Buy bonds as well and you become all of a shareholder of, borrower from and lender to the same corporation.
Banks will always go on issuing bonds, but the good news is the number of non-financial sector corporations actively seeking to issue bonds is growing, providing investors with the opportunity for greater diversity within their portfolios. Innovative new lending products are now enabling those corporations that aren’t mega-caps enjoying “investment grade” credit ratings, but rather are unrated, to issue bonds.
Bonds issued by non-rated corporations offer higher yields to compensate for higher risk. Again it must be remembered that a bond holder is only at risk of losing their money if that corporation goes out of business. Even if the corporation goes into receivership, bond holders must be reimbursed before any available funds can flow to equity holders.
Alongside what we might call straight-up-and down bonds, many corporations issue what are known as hybrid securities, which offer a mix of equity and debt characteristics. The simplest of the hybrids is the “convertible bond”, which is issued as a bond instrument but converts to equity if the listed share price of the issuer exceeds a predetermined level.
On face value, convertible bonds are a “best of both worlds” investment proposition. In times of financial market weakness, it’s safest to be holding bonds. In times of financial market strength, an investor benefits more from holding equities. Convertibles act as a bond – providing a coupon payment and repayment of the original investment at maturity — up until a rally in the share price converts them into shares, which then attract dividends and don’t mature.
The reality is, however, most of today’s listed hybrids are not simple convertibles, but a mind-boggling array of convertible, converting, redeemable, redeeming, resetting, step-up, stepped up…the list goes on…concoctions, both in the form of bonds and preference shares (which are debt, not equity, instruments but that’s a whole other story) that each have their individual and often highly complex quirks.
The bottom line is it is easy to stumble into a hybrid investment while not fully appreciating its idiosyncrasies, only to find it does not actually behave the way you assumed. Investors contemplating hybrid investments, and such instruments are listed on the ASX, are strongly urged to seek professional advice beforehand, from someone who one can be sure is themselves well versed in such products.
Delving into the complex world of hybrids may not be advisable for everyone, but simple investment in corporate bonds offer the retiree or investor planning for retirement with a sensible means of portfolio diversification, smoothing some of the risk of stock market volatility and offering an alternative to a property market that by now, for the time being at least, may have seen its best days.
Bond investment may not get you on that yacht, but it may mean you avoid stacking those shelves.
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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