Fixed interest investing

(Article by Geoff Malkin, Managing director Bond Adviser, first published in Equity Feb 2017)

Editor's note: A simple definition of fixed interest investments is that they are instruments which offer investors a regular income for a specified term with the expectation that the principal will be repaid at the end of the term (maturity date). The following article contains quite sophisticated information which delves more deeply into the topic.


Why do Australian retail investors have a low allocation to direct interest rate securities - what’s available and how does it compare to other asset classes?

Overview

Australian superannuation funds have around a 50% average allocation to shares — the second highest in the developed world — with APRA regulated industry funds allocating around 17% to fixed interest.

This compares with an average allocation to shares of 56% in Japan, 50% in the Netherlands, 35% in the UK, and 27% in the US. Australian SMSFs have just above 1% of an estimated $611 billion of assets invested in direct debt or fixed interest securities. The latter shows how exposed a rapidly ageing investor population is to ‘riskier’ assets at a time when capital preservation is important or simply for those investors seeking a more defensive strategy.

The question then is “if you are prepared to buy the equity of a company why wouldn’t you buy the debt of the same company”?

Retail fixed interest markets in Australia versus overseas

 In contrast to the experience of retail investors in Australia, overseas investors have benefited from statutory reporting on traded prices, easy to use active bond trading platforms and plenty of research on the asset class. They even discuss their bond purchases just like Australians discuss share trading.

In Australia many investors say “we get our income from a combination of term deposits and hybrids or A REITS – that’s our fixed interest exposure.” This simplistic approach to income investing demonstrates how uninformed investors and some advisers have become. It is not necessarily their fault though, there isn’t a developed platform for trading a broad range of diversified income securities in Australia nor sufficient market education.

Key reasons for low fixed interest allocations

  • Different terminology to equities
  • Franked dividends on shares are able to offset other income
  • Capital gains on fixed interest are taxed as income
  • Managed funds and model portfolios more easily administered by advisers than direct fixed interest securities 

Terminology

 There is a general lack of clarity and understanding of fixed interest terminology in Australia.  For example terminology in recent Tier 1 hybrid Product Disclosure Statements are a case in point with terms such as ‘non viability’[1]  and ‘trigger events’[2]  .

Franked dividends on shares

Franked dividends paid by Australian companies can make investing in shares overwhelmingly more attractive compared with fixed interest. Furthermore, franking credits can offset other income in a portfolio and make them more irresistible to investors irrespective of the potential for capital losses on the underlying share.

Tax

Capital gains on fixed interest are treated as income and taxed at marginal tax rates.

Managed funds and model portfolios

Income portfolios have been available for some time via managed funds and more recently model portfolios in wrap accounts and ETFs. These products have generally been designed to make life easier for advisers but lose the benefits of direct fixed interest investment. The question is whether at current low interest rates, the “after fees” or ‘net return’ justifies investment in these instruments compared with cash and term deposits? Also, they may not match the cashflow requirements of individuals.

The universe of income securities in Australia

Similar to equities, interest rate securities come from a number of issuers (borrowers) across different sectors and have a number of different cash flow options:

  • Government — fixed rate, floating rate, CPI indexed (capital/annuity)
  • Infrastructure — fixed rate, floating rate, CPI indexed (capital/annuity) 
  • Banks/financials — term deposits, unsecured, subordinated, hybrid debt/equity
  • Companies — unsecured, subordinated, hybrid debt/equity both fixed and floating rate.

Within this mix of issuers, credits and cash flows there would seem to lie the potential to structure different styles of income portfolios which can offer capital preservation, defined income streams and investment diversity. However, unless you qualify as a wholesale (or sophisticated) investor the options to build a diversified income portfolio may be limited.

Access to Australian interest rate securities

The ability to access the fixed interest market in Australia can be split in two based upon investor classification:

  1. Sophisticated or wholesale investors (S 708 Corporations Act) have access to all ASX exchange traded products and may also access unlisted corporate bonds from specialist fixed interest dealers.
  2. Retail investors - can only construct a fixed income portfolio limited to traditional term deposits, ASX Debt and Hybrid securities, Treasury Bonds and XTBs all issued under a public prospectus.

There are approximately 65 ASX listed interest rate securities total approximately $60 billion. By comparison the unlisted bond and debt market totals $1.5 trillion but has previously been confined to domestic and offshore institutions.

Comparison of Income earning assets

Payment of interest on TD’s, bonds and hybrids are effectively contracted between borrower and investor, whereas A-REITS and shares make no such promise with higher returns expected through growth. The long term performance (10 years) of these income assets is displayed in Figure 1.

Credit risk

Whilst equity investors are concerned with growth and are more tolerant to volatility, fixed interest investors are concerned with the timely interest payments and the return of capital on maturity. Therefore, fixed income analysts focus on the risk that the borrower may default on either of these issuer obligations.

As the ASX interest rate market is dominated mainly by bank hybrid securities it is worth having a look at the typical capital structure of the top banks.

Like all financials, the major banks are subject to capital adequacy requirements (i.e. regulatory capital ratio) imposed by APRA and try to adhere to worldwide standard ratios under Basel III[3]. In the unlikely event of a banking crisis or share market collapse, term deposit holders would be protected but holders of hybrid securities issued by a bank would be converted (or written off) to absorb any unforeseen losses. At this point Tier 1 hybrids investors (highlighted) have comparable rights to common equity holders and may lose their investment in a collapse.

For corporates with heavily geared balance sheets the above scenario may be worse and A REITS with high LVR’s will also be affected.

Interest rate risk

Often upwards movements in interest rates adversely effects shares and investments such as A-REITS (see the effect of the recent rise in bond yields on A REITS in Fig 4). Companies find it more expensive to fund their business at higher rate levels, the equities market can lose value, and long dated bonds can lose capital (yields up prices down). 

Floating Rate Securities (or Notes, FRN’s)

What is also little known is that a large number of interest rate securities protect investors in this scenario.  These are known as Floating Rate Securities (or FRN’s) - amongst these are a number of ASX listed hybrid securities.

How FRN’s work

Assume the current BBSW [1] is 2.00%, and a security has an issue margin of 3.10%. So, for the first 90 days, the investor receives a total return of 5.10%. For the next, and subsequent 90-day periods, the BBSW may be higher or lower, but the investor will always receive the 3.10% margin on top of the BBSW (reset each 90 days).

Lesson

“Understand when rates fall the price of a bond increases (and vice versa). Floating rate securities simply adjust up or down with movements in short rates “.

The fall in long bond rates since the GFC indicates that Treasury bonds (whilst appearing a dour investment) have performed admirably especially given their sovereign credit.

Conclusion

A range of direct interest rate securities are available to Australian investors. It is only a matter of self-education, understanding the terminology and the difference between interest rate and credit risk.

The low allocation to direct interest rate securities can mainly be explained to a lack of market literacy and the less tax advantageous position of interest rate securities versus share dividends.

Self-educate yourself on this asset class where possible. If there’s unfamiliar terminology it’s wise to seek out a specialist fixed interest adviser if you want to transact ‘direct’ income securities.

For further information please visit www.bondadvisor.com.au


[1] non-viability (PNV) is the second line of defence before a public injection of funds is necessary to support the issuer or conversion or write-off of some or all loss absorbing securities (preference shares/ capital notes) is necessary because, without it, the institution would become non-viable
[2] Under new BASEL 111 guidelines, the terms and conditions of all capital instruments issued by internationally active banks on or after 1 January 2013 which are to be counted towards Additional Tier I or Tier II capital must specify that they are to be either written off or converted to common equity upon the occurrence of certain trigger events (or subject to applicable laws which achieve the same result).
[3] a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector.
[4] Bank Bill Swap Rate