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Five things bond investors are doing now

There has always been two easy ways for bond investors to increase returns: by investing for longer terms or by increasing risk by moving down the credit rating spectrum. While both of these options remain popular, here are some trends among bond investors at the moment.

1. Supply is down and fewer investors are selling

Not long ago, we had access to plenty of bonds and could readily find sellers in the market. Over the last few months, we've seen a number of forces at play including:

  • the RBA cutting the cash rate to 1.5% and investors realising interest rates will be much lower for much longer
  • a number of favoured bonds have matured, putting cash in investors' pockets, much of which went back into buying other bonds
  • limited new supply of corporate, non-financial bonds in Australian dollars - domestic issuance is low with many corporations issuing into the US market or reluctant to take on more debt.

Combined, all of these factors have cut supply. We've seen growing appetite for bonds, and while they can still be found, investors may need to wait a week or two to have their orders filled.

2. If they are selling, it’s inflation-linked bonds and cyclical resource bonds

Low inflation and rebounding resource prices have prompted sales of some holdings.

The outlook for inflation is low, in line with low growth rates. Headline inflation for the June 2016 quarter was 0.4% and trimmed mean for the past year 1.7%, lower than the Reserve Bank Board target range of 2% to 3%. Lower inflation results in lower growth in capital indexed bonds and lower income compared to a higher inflationary environment.

Theoretically, the global stimulus should work to increase inflation and we still view this as a risk worth protecting against. Two favoured inflation-linked bonds are seeing some turnover: Australian Gas Networks (previously Envestra) has a capital index bond maturing in 2025 with a yield over inflation of 2.87% per annum and Sydney Airport, a similar bond maturing in 2030 with a yield over inflation of 3.23% per annum. Even if inflation drops to zero or is negative, these fixed yields will help maintain a positive return.

The strong performance in resource bonds since Christmas – for example Fortescue Metals Group USD bonds are up between 30 and 80% - has seen some investors take profit and invest in other bonds that they consider have a better potential to outperform.

3. Diverging groups - one preferring investment grade, the other high yield

There has been a clear split in strategy, generally between institutional and private investors.

In Australia, institutional and middle market clients are often bound by mandates that restrict investment to certain minimum investment grade ratings for maximum terms. They are natural buyers of high grade bonds, with recent additional emphasis on quality. These investors also look for bonds that have stand out returns. A few months ago, we saw good institutional buying of a highly rated AUD Swiss Re old style hybrid paying 4.25% which we expect will be called in May 2017.

High yield bonds help deliver much needed income to SMSFs in drawdown and it’s perhaps natural that they would seek additional risk in this market. Our suggestion to anyone with this strategy has been to adopt a more equity-like approach and invest smaller amounts so that if any company gets into difficulty, then it has much less impact on the overall portfolio.

4. Buying longer dated, fixed rate bonds – investors don’t mind adding duration

Earlier this year, investors thought we had hit the bottom of the interest rate cycle and adopted a short duration strategy to prevent losses on long dated fixed rate bonds should interest rates rise. The thinking has shifted and they're now comfortable investing for much longer for better returns.

(Note: Duration is a measure of the price sensitivity of a bond to interest rate movements. Typically, duration provides an estimate of how a bond will change in price for a 100 basis point or a 1% movement in interest rates. For example, say interest rates change by 1% then a $100,000 par value bond with a six-year modified duration could expect a corresponding 6% change in its price, that is 1% x 6 years = 6% change. If the traded yield on that security moved up by 1% the next trading day, then the market value of that bond would fall roughly 6% from $100,000 to $94,000. Alternatively, if the traded yield on that security declined by 1% the next trading day, then the market value of the bond would rise by 6% to $106,000).

Long-dated, fixed rate bonds of ten years or more are growing in popularity. For example, gold miner Newcrest has a US dollar bond maturing in 2041 paying a yield to maturity (YTM) of 5.35% per annum and Canadian diversified power producer, TransAlta has a bond maturing in 2040 with a YTM of 6.91% per annum. Both of these bonds are investment grade rated BBB-.

5. Adding USD and GBP bonds to their portfolios

A growing trend has been the addition of foreign currency bonds especially with those investors who hold foreign currency deposit accounts or who have assets in other countries. The strategy also provides a hedge against the depreciation of the Australian dollar and allows wholesale investors to access a very broad range of companies and other entities, adding further diversification to their portfolios.

Recent popular targets have been BHP Billiton in USD and GBP, and others, mainly in USD - Newcastle Coal Investment Group, IAMGOLD and the latest addition is a range of bonds from information technology producer, Dell Technologies. The yield to call for these bonds range from 4.62% p.a. for the BHP Billiton USD subordinated bond with a first call in 2025, to the Newcastle Coal bond maturing in 2027 with a yield to call of approximately 10.5% p.a.

Note: Prices quoted are accurate as at 8 September 2016 but subject to change.

 

Elizabeth Moran is Director of Client Education and Research at FIIG Securities, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual.

 

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