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Let’s stop calling them ‘bond proxies’

Imagine if you could nominate the one factor which has been most important in driving share markets to recent all-time highs. It would not only explain the past decade, but it could guide your future investing. So, what’s your suggestion?

Famous US fund manager, Howard Marks, has been publishing a quarterly memo to his clients for 30 years, and he’s seen it all in investment markets. In his latest memo, he answers this question without qualification:

“Low rates reduce the discount factor used in calculating the net present value of future cash flows. Thus, all else being equal, there’s a direct connection between declining interest rates and rising asset prices.

I consider this to have been the dominant feature of the world of finance over the last ten years.

Low rates on savings and fixed-income investment drive investors to accept increased risk in order to pursue decent return in a low-return world.”

What if, in this search for yield, investors could have the best of most worlds: predictable income as offered by term deposits or bonds, high yields no longer available from fixed income, and the potential for some capital growth. Almost everything except a bond’s defined maturity value at a future date.

Welcome to the world of so-called ‘bond proxies’.

A ‘proxy’ can be ‘used to represent the value of something else’. Certain types of investments such as infrastructure and commercial property often have long-term monopoly locations with contractual payments from governments or large companies. Think airports, roads, ports, power stations, bridges, office blocks and distribution centres.

Are these three types of investment really alternatives to bonds or term deposits, or is bond proxy a misnomer? We’ll consider this in the context of listed securities, but hundreds of unlisted funds offer each asset class as well.

1. Listed infrastructure

Many companies listed on Australian exchanges offer revenue streams that have some bond-like characteristics. Sydney Airport (ASX:SYD) has a monopoly on air traffic into Australia’s largest city. It has exceptional pricing power, as anyone who has parked there or bought a coffee will know. It’s as much a shopping centre and a car park for captive consumers as it is a place where planes arrive and depart.

But it is not immune from equity-like risk. A global epidemic similar to SARS or an economic recession might reduce traveller numbers. Conflict between major super powers, or even war, could dramatically impact global travel. It’s conceivable that a cyber attack could hit the airport’s systems, or terrorist activity threaten the safety of flying.

Most of these risks relate to global travel, so what about Transurban (ASX:TCL), which owns many of Australia’s major toll roads? When the Eastern Distributor opened in Sydney in 1999, the toll for a car was $3.50. It’s now $7.69. What a great business, especially when the alternative is a painful traffic jam. But what about the future impact of driverless vehicles, or the dates when the concessions lapse and return to the government. One day, will we have flying vehicles which do not need roads?

Other infrastructure stocks include the APA Group (ASX:APA) which owns gas pipelines in every mainland state and territory, delivering half of the nation’s gas usage. Aurizon (ASX:AZJ) is a leading rail freight operator, transporting 250 million tonnes a year across a national network. These businesses are the essential plumbing of the Australian economy, and are considered defensive assets and less prone to economic downturns.

One way to reduce specific company risk to invest in an infrastructure fund listed on the ASX, and here are the choices:

  • Argo Global Listed Infrastructure Limited (ASX:ALI)
  • ETFS Global Core Infrastructure ETF (ASX:CORE)
  • AMP Capital Global Infrastructure Securities Fund (ASX:GLIN)
  • VanEck Vectors FTSE Global Infrastructure (Hedged) ETF (ASX:IFRA)
  • Magellan Infrastructure Fund (Currency Hedged) (ASX:MICH)
  • Vanguard Global Infrastructure Index ETF (ASX:VBLD)

These funds have different structures which may affect their appeal. Argo is a Listed Investment Company which means the shares can trade at a discount or premium to the value of their assets. This ‘open-ended’ form is at once an opportunity and a problem.

Both Magellan and AMP are actively managed, while the others replicate infrastructure indexes and offer lower fees.

2. Listed property

The more common name for listed property is Australian Real Estate Investment Trusts, or A-REITs, which are trusts which hold different types of property. The sector is currently offering a 4.5% dividend yield, and contractual rental arrangements make profit and dividend growth reasonably predictable at about 3 to 4% per annum. There are also property managers who operate the funds.

There are dozens of listed property investments, too numerous to list here, including smaller trusts in specialist segments. The leading names are Stockland (ASX:SGP), Scentre (ASX:SCG), GPT Group (ASX:GPT), Goodman (ASX:GMG), Charter Hall (ASX:CHC) and Unibail-Rodamco-Westfield (ASX:URW).

During the GFC, many listed property trusts fell heavily in price because they carried high gearing and had ventured overseas into less-understood markets. Business methods are far better now, with lower gearing and a strong focus on Australia.

A crucial factor in A-REITs is the division into segments of office, retail, industrial and residential, and investors should consider the future merits of each as an investment. In 2018/2019, for example, the property fund managers, Charter Hall Group (up 72%) and Goodman Group (up 60%) both benefited from strong demand for the A-REITS they manage in growth segments such as commercial offices and industrial logistics. However, Unibail-Rodamco and Scentre fell 27% and 8% respectively due to concerns about exposure to the discretionary retail sector.

There are also property ETFs such as the Vanguard Australian Property Securities Index ETF (ASX:VAP), the SPDR S&P/ASX200 Listed Property Fund (ASX:SLF) and AMP Capital’s Global Property Securities Fund (ASX:RENT). A listed vehicle that combines both infrastructure and listed property is the BetaShares Legg Mason Real Income Fund (ASX:RINC) which holds A-REITs, gas, electricity, port and toll road listed asses in one fund.

3. Equity income funds

Many investors are turning to higher dividend yields to compensate for lower fixed income returns, but the move comes with obvious risks. Over the last 75 years, the Australian share market has experienced 40 falls of over 10%, so share investors must expect this level of correction regularly over all investment cycles. Worse, in 1974, 1987 and 2007, the market fell by over 50%, often with little warning or valuation excesses.

Every investor has a different appetite for risk, and just because a fund is called ‘equity income’ does not mean it is less likely to fall in value. It might have an income focus, but it is still an equity fund.

Despite the experience in a stock like AMP (ASX:AMP) which has suspended its dividends, or Telstra (ASX:TLS) which has reduced its dividends, most companies sustain their dividends during a market sell off. Dividends are more resilient than share prices, and equity income funds certainly produce higher income as some compensation for the added risk. An equity income fund in the current market can produce a dividend yield of around 6% or 8% grossed up for franking credits.

Equity income funds concentrate their investments in the large dividend-paying stocks of banks, Telstra, Wesfarmers and more recently, BHP. It is a stretch to call these investments ‘bond proxies’, as banks are leveraged companies exposed to economic cycles, and resource companies are subject to volatile commodity prices. Investors should consider the total return, including capital gains and losses, not only income. Nevertheless, 8% fully-franked is difficult to resist for at least part of a portfolio.

Examples of listed equity income Exchange Traded Funds (ETFs) are:

  • Australian Dividend Harvester Fund (ASX:HVST)
  • Vanguard Australian Share High Yield Fund (ASX:VHY)
  • iShares S&P/ASX Dividend Opportunities ETF (ASX:IHD)
  • SPDR MSCI Australia Select High Dividend Yield Fund (ASX:SYI)
  • BetaShares Legg Mason Equity Income Fund (ASX:EINC)
  • Equity Yield Maximiser Fund (ASX:YMAX)

Other variations include a fund specifically investing in Australian banks, the VanEck Vectors Australian Banks ETF (ASX:MVB), global income funds such as the S&P500 Yield Maximiser (ASX:UMAX) and actively-managed Listed Investment Companies like Plato Income Maximiser Limited (ASX:PL8).

Don’t be tricked by the ‘bond proxy’ label

As with share investments, however, they are subject to overvaluation when investors chase predictable revenue, and their share prices will fall in a major market correction. They may reduce dividends or suffer adverse market reaction if interest rates rise.

The macro environment of central banks injecting liquidity and pushing down interest rates has been a perfect environment for so-called bond proxies, but the threat of trade and currency wars and slowing economic growth might push bond proxies more into the equity proxies camp.

The reality is that although cash flows may be long term and more predictable than some companies, the shares listed above lack a crucial characteristic of a bond: the contractual obligation of the issuer to repay principal at maturity. Regardless of what happens to interest rates, a bond with a maturity value of 100 will pay 100 except where the issuer faces financial difficulty or default (in the universe of investment grade bonds rated AAA, AA, A and BBB, the average default rate is around 2.5%). Although bonds can suffer a fall in value during their term as rates rise, so too will bond proxies which benefitted from the rate fall. During tough market conditions, bonds are likely to outperform, and bond proxies do not carry the same defensive characteristics as term deposits.

Investors should resist the urge to attach the bond proxy label on infrastructure, property and equity income, but accept them for what they are. They have a legitimate role in a portfolio as income-producing, quality assets that will be subject to market forces with no guarantee of a return of capital at some future maturity date.

 

Graham Hand is Managing Editor of the Cuffelinks Newsletter. This article is general information and does not consider the circumstances of any investor.

 

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7 Comments
BeenThereB4
August 10, 2019

Good reading Graham.

Readers will remember during the GFC AREITS which invested in US properties (financed by expensive US debt) were deservedly taken to the cleaners. The doors for refinancing were firmly closed when time came to refinance … and assets had to be sold in weak markets.

But more recently critics of so-called bond proxies do not acknowledge that in the present cycle of low interest rates, the debt-heavy utilities and AREITS are refinancing maturing (and relatively expensive ) debt in lower cost debt.

Tony Dillon
August 09, 2019

A “bond proxy” it may not be, but equity income stacks up quite well in this low interest rate environment.

For example, the yield on ten year government bonds is now less than 1%. Consider the 3.25% Treasury Bond maturing in April 2029. It closed this week at a price of 122.9 on a yield of just 0.89%. With face value of 100 paid at maturity, if purchased now at 122.9, a capital loss of 18.6% is locked in, compensated by the fixed annual 3.25% coupon being well in excess of current market yields.

Now consider equity income, say a bank stock, on a dividend yield of 6% before franking. Say one invests 122.9 now in the stock. With annual dividends of 7.4, assume the stock is held to April 2029 and sold at that time. Then a yield of 0.89% would imply a capital loss of 53.5%. That is, the stock is sold at 57.1.

So the stock would have to more than halve in value to realise the same yield as the bond over the same period.

The chance therefore that the stock outperforms the bond in terms of yield would appear to be high. And with a dividend yield six times more than the yield on the bond, why wouldn’t it.

John Nichols
August 09, 2019

Default definition can be mere missing a coupon payment. Investment grade losses of capital are rare

Adrian
August 08, 2019

Bond proxy should be ok if people take note of the word “proxy” and that this is referring to bonds generally not Gov bonds or term deposits. Many bonds also do not guarantee a capital return there is always credit risk.

Frank
August 08, 2019

Many fund managers jumped aboard the ‘equity income’ label as if that someone made their funds less risky than other equity funds. Selecting stocks based on their income and not share price potential is not an ideal way to run a share portfolio. More a constraint.

SMSF Trustee
August 12, 2019

Frank that’s NOT how most equity income managers do things. I use them in my fund and they deliver exactly what they promise – a return that is a bit less than shares over time, but with a lot less volatility than shares and a higher income to growth ratio than a share fund. They do this through their use of options strategies and not based on dividend yields. They aren’t as stupid as you seem to think they are.

Graham Hand
August 12, 2019

Thanks, Adrian, yes, closed-ended is correct. We’ve changed it and put in an short explanation.


 

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