Investors should consider the Product Disclosure Statement (PDS) available from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (AMP Capital) for the AMP Capital Corporate Bond Fund (Fund) before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity of the Fund and the issuer of units in the Fund. Neither AMP Capital, nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this document, AMP Capital
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W
hen planners look around the investment universe, the return outlook everywhere is grim. But fixed income is a particular problem. Yields on bonds and term deposits have slumped on the back of rate cuts and stimulus. If you invest now and interest rates rise, as many expect, you could face big capital losses.Many investors are chasing yield and investing in riskier hybrids. But planners and their clients don’t have to take big risks to get yield and income, even in this environment.
There are investment options, such as floating-rate notes, which have decent yields, but also protect against interest-rate rises. Planners can also look at more complex managed options, including income and absolute return funds.
And despite low yields, analysts urge planners not to forget bonds’ primary role: a portfolio diversifier.
“Don’t give up on what traditional bond funds bring to the table, and why you have fixed income in the first place,” says Tim Murphy, co-head of fund research at Morningstar Australasia.
In this complex investing environment planners need to be clear about their objectives for fixed income. Are they seeking portfolio diversification, or are they looking to generate income?
“Going forward, it’s all about separating those goals,” says Simon Warner, head of macro markets, fixed income, at AMP Capital.
One of the key roles of fixed income has always been diversifying a portfolio: when equities fall or crash, a flight to
GETTING CREATIVE TO
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Challenging conditions make
it more important than ever
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Ben Power reports.
AMP Capital has a 40-year track record of fixed income investing.
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safety usually sees government bonds rise. But with bond yields so low, and many investors expecting rates to increase, some question whether bonds are in a position to play their traditional diversification/ defensive role in a portfolio.
Warner, who manages AMP Capital’s Australian Wholesale Bond Fund, says that last year those concerns were warranted. But after recent Australian government bond yield increases, valuations mean that, once again, bonds can play their defensive role. Yields on 10-year Australian government bonds are up about 100 basis points from their lows in the middle of last year, when yields fell below 3 per cent.
“That is much closer to fair value,” Warner says. “Therefore, the prospects going forward are much better at this level of yield than if we were speaking last October or November.”
Central banks around the world have pushed yields to historic lows, and Warner says US bonds were never good value when they were yielding 2 per cent. US Federal Reserve chairman Ben Bernanke has recently talked about tapering of quantitative easing, which would likely see bond yields rise.
There has been a lot written about the prospect of a bond bubble bursting.
“As the global economy improves, bond yields will drift higher,” Warner says. “That’s fine as long as it’s in line with a better economy and improvements in the value of risk assets such as equities. But we don’t really believe there is a bubble in bonds about to be burst.”
But Warner says that bond investors also need to be clear about which commentary relates to local bonds and which relates to international markets. He, and others, note that in Australia, upward pressure on bond yields is very limited.
“Australia continues to be soft,” Warner says. “It’s reasonable to expect our economy to underperform against what we’re used to as the mining boom peters out. We also don’t think there is a local bond bubble.”
But many retail investors are focused on fixed interest for income. They have been spoilt in past years with term deposits. But with rate cuts, those days are over.
“I wouldn’t want to be in a lot of retirees’ shoes at the moment,” says Elizabeth Moran, director of education and fixed income research at FIIG, of the low-return environment.
Floating-rate notes
The coupons on floating-rate notes are tied to a benchmark – usually the bank-bill swap rate – plus a margin. So when official rates rise, the coupon rises in line with rates and the bond price remains stable.
Moran says that it’s important to hold all three types of bonds – inflation-linked, fixed-rate and floating – in a portfolio.
“But you’d look at adding additional floating-rate notes if you thought we were at the bottom of the [interest rate] cycle,” she says.
The Vero Insurance Ltd floating-rate note, which matures in 2015, has a running yield of 3.38 per cent; but the Genworth Financial Mortgage floating-rate note, which matures in 2016, has a running yield of 7.16 per cent.
AMP Capital’s Warner agrees that floating-rate notes are a “great idea if you’re thinking about preserving income”.
“If you’re purely looking at bonds through the lens of income, it’s important to be on the front end of the curve,” he says.
Warner says floating-rate notes are not a substitute for diversification, but are a good substitute for the likes of term deposits.
Downer Group Finance Pty Ltd 29/11/2018 Fixed Senior debt 5.75% 5.75% 99.990 $10,000 $9,999
Genworth Financial Mortgage 30/06/2016 Floating Lower
Tier 2 5.69% 7.16% 105.750 $10,000 $10,575 Vero Insurance Ltd 07/09/2015 Floating Lower
Tier 2 5.08% 3.38% 97.150 $10,000 $9,715 DBCT Finance Pty Ltd
(Dalrymple Bay) 09/06/2021 Floating Senior debt 6.13% 3.18% 90.494 $10,000 $9,049 Envestra Ltd 20/08/2025 ILB Senior debt 6.17% 3.24% 116.877 $12,475 $11,688 Sydney Airport Finance 20/11/2020 ILB Senior debt 6.65% 3.86% 124.984 $12,847 $12,498 $85,322 $85,307 Prices accurate as at 4 September 2013 and subject to change Minimum initial investment $50,000
Black = retail and wholesale investors, red = wholesale only ILB - Capital indexed bond, these are linked to inflation. FIIG assumes CPI of 2.5% per annum (the mid point of the RBA inflation target) YTM - Yield to maturity incorporates any capital gain or loss at maturity or first call plus interest payments, using the pricing provided
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SIMON WARNER
Jason Blumberg, senior investment analyst at van Eyk, says retail clients generally want steady income with capital protection: they want to earn around 5 to 6 per cent a year without losing their money. If investors are chasing income, his advice is to get out of government bonds, because rates are so low.
“There is only one direction for them to go [up], and you could end up getting quite hurt,” he says.
In the past few years, investors have substituted bonds with term deposits, he notes, while direct bond holdings have been focused on hybrid securities. But many analysts are now warning of the growing risks of hybrids – particularly with recent issues, which have more terms and conditions that make them more equity-like. FIIG’s Moran says hybrids do provide the yields investors are looking for. “But I’m not sure investors are factoring risk into the situation,” she says.
FIIG prefers older hybrid issues, which are less equity-like, from companies such as National Capital Instruments (a subsidiary of National Australia Bank), Rabobank, Swiss Re and AXA SA.
So where else do investors turn? There are a number of options, particularly
AS THE GLOBAL ECONOMY IMPROVES,
BOND YIELDS WILL DRIFT HIGHER. THAT’S
FINE AS LONG AS IT’S IN LINE WITH A
BETTER ECONOMY AND IMPROVEMENTS
IN THE VALUE OF RISK ASSETS
To take bond opportunities fast
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rate bonds, as there has been in recent years. (Fixed-rate bond prices rise when interest rates fall; but they help investors meet expenses, and the income is known, as is the overall rate of return if they hold the bonds until maturity.)
With so much money being printed around the world, Moran says it is also worth looking at inflation-linked bonds. She says if there is a spiking of growth, inflation could rise quickly.
“Hold some of those as protection,” she says, adding that many are paying margins of 4 per cent over CPI.
“It’s like getting TD [term deposit] rates with an inflation hedge,” she says. “In this environment, why wouldn’t you do that?”
Sydney Airport Finance inflation-linked bonds, for example, have a running yield of 3.86 per cent. Moran notes that the running yield doesn’t make any inflation assumption. The rate is paid on the growing face value of the bond. If quarterly inflation is 3 per cent, the face value would rise from $100 to $103 and the 3.86 per cent is paid on the new face value of $103.
But with interest rates possibly rising, a major focus has been on floating-rate notes. (See box on p38.) Planners and their clients don’t have to buy floating-rate notes directly. They can get exposure through certain “income” funds, including “absolute return” funds, which are growing in popularity. Blumberg says absolute return funds are good for the right type of investor, though they do employ complicated strategies.
“They’re good if you’re comfortable with hedge-fund type investments,” he says.
Absolute return funds are capable of getting investors closer to double-digit returns, Blumberg notes, but with extra risk. He likes, for example, the GAM Absolute Return Bond Fund.
“It has a good track record over time. It does use quite a few options strategies and long-short bond strategies,” he says.
Blumberg says “income” funds also have a role in this low-rate environment. He likes Kapstream Absolute Return Income Fund and the Macquarie Income Opportunity Fund.
“They’re a really good alternative to term deposits if you’re looking for a bit of a premium over cash,” he says.
Those funds invest in high-quality credit securities and short-term corporate debt used for funding working capital requirements, which is very short-term and therefore reduces risk – particularly interest-rate risk.
Morningstar’s Murphy also likes the Macquarie Opportunity Income Fund, along with the Perennial Tactical Income Trust. “They have very experienced management and have been running mandates for a long time,” he says.
Murphy says many funds have created absolute return mandates in the last few years. “They [Macquarie and Perennial] have been running money that way for
a long period of time; it’s not a new thing for them.”
The current market is particularly challenging for investors, with returns low across most asset classes, including fixed income. That means investors and advisers need to be crystal clear about what they’re trying to achieve; and when it comes to income, advisers will also have to be more creative than they have been in the past when term deposits delivered strong returns. But there are options, particularly floating-rate notes. Investors will also have to be mindful that chasing yield means higher risk.
MARKET EXPECTATIONS OF FUTURE INTEREST RATES
Date 3-month bank bill
swap rate (BBSW) (%) 10 year Commonwealth government bonds (%)
3M 2.58 2.39 6M 2.58 n/a 1Y 2.60 2.46 2Y 2.92 2.61 3Y 3.27 2.89 4Y 3.60 3.16 5Y 3.83 3.28 6Y 4.03 3.49 7Y 4.21 3.68 8Y 4.35 3.84 9Y 4.47 3.98 10Y 4.55 4.04 15Y 4.88 4.54
Source: Bloomberg, FIIG Securities Limited Rates as at 4 September 2013
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MARKET EXPECTATIONS OF FUTURE INTEREST RATES
Date 3-month bank bill
swap rate (BBSW) (%) 10 year Commonwealth government bonds (%)
3M 2.58 2.39 6M 2.58 n/a 1Y 2.60 2.46 2Y 2.92 2.61 3Y 3.27 2.89 4Y 3.60 3.16 5Y 3.83 3.28 6Y 4.03 3.49 7Y 4.21 3.68 8Y 4.35 3.84 9Y 4.47 3.98 10Y 4.55 4.04 15Y 4.88 4.54
Source: Bloomberg, FIIG Securities Limited Rates as at 4 September 2013
