The value of bonds in an investment portfolio

Any investment text will tell you that bonds are an essential asset class in a balanced investment portfolio. Bonds add negatively correlated diversity to a portfolio and reduce the volatility of the returns generated by the portfolio, or so the theory goes.

As we know there is theory and then there is practice, and practice will not always produce the results predicted by theory. Moreover, from a traditional portfolio construction perspective, investors have quite a bit of discretion over how far their practice diverges from theory.

To give a simple explanation of what is meant by this: theory considers a portfolio invested in just two asset classes. Investors can hold risky equities – shares in the ownership of companies, and risk free assets – government bonds.[1]

Not surprisingly, the characteristics of the assets in this portfolio are consistent with the characteristics of such assets found in the American market. The shares will pay little or no dividends and will be held for expected capital growth, and the bonds will pay regular fixed rate coupons.

Thus the shares will allow the capital value of the portfolio to grow, while the bonds will generate income to meet an investor’s recurrent expenditure or other income needs. This is good while economic conditions remain stable.

In addition, bonds can also provide a portfolio with a cushion or buffer, when economic conditions are not stable. The capital value of bonds that pay a fixed coupon will move up and down as market interest rates change.

If economic growth is strong, it could well be inflationary and the central bank will raise market interest rates to curb economic growth and offset inflationary risks. If market interest rates rise, then the capital value of a fixed coupon bond will fall because the value of the fixed coupon paid is below current market expectations.

Thus, in a strongly growing economy the value of the shares held in the portfolio should increase but the capital value of the bonds in the portfolio will offset this to the extent that the capital value falls.

In this situation, it is tempting to consider not holding bonds. But in a long term investment portfolio, as all portfolios should be, the value of bonds as something more than a source of income, becomes apparent when the economy turns down.

In an economic downturn, the central bank will cut interest rates to stimulate economic growth. Share prices will be falling as economic growth falls but the capital value of the bonds will increase as market interest rates fall below the value of the coupon paid.

Thus, an appropriate allocation to bonds within an investment portfolio can maximise returns while minimising the overall risk of the portfolio. This is the theory and the trick is to work out what the appropriate proportional allocation to shares and bonds is.

Leaving aside proportional asset allocation, retail investors in Australia can put theory into practice. Retail investors can construct an investment portfolio that contains shares listed on the ASX, and to the extent that Australian companies tend to pay larger dividends than US companies, so much the better, the shares should not exhibit the same price volatility.

Australian investors can also add fixed coupon, Australian government bonds (the risk free assets) to their portfolios, as these too are listed on the ASX. These Australian government bonds will have the same performance characteristics that are expected in the theoretical investment portfolio.

However, in this new post-GFC world of historically low interest rates, government bond yields do not look very attractive, with (at the time of writing) yields ranging from 0.00% to 3.57% per annum for bonds with terms to maturity ranging from next year to 2037.

To boost returns, retail investors can look at bonds issued by Australian companies, that are listed on the ASX. But doing so will introduce two forms of risk not yet considered: one is interest rate risk and the other is credit risk.

Virtually, all of the debt securities listed on the ASX pay floating rate coupons rather than fixed rate.[2]  This is a key difference because the cushioning effect of changes in the capital value of bonds, as market interests move up and down, is lost.

Floating rate coupons move up and down with market interest rates and capital value will remain stable, all other things being equal.

Thus, in a rising interest rate environment, investors can expect to earn more income but will earn less as interest rates fall. Just like with bank term deposits in recent years.

This brings us to credit risk.

The lower the credit quality of the company issuing the debt securities, in other words the greater the likelihood that the issuer may default over the life of the debt securities, the higher the coupon that should be paid when the debt securities are issued, to compensate for the inherent credit risk.

Similarly, greater compensation will be demanded by the market if an issuer’s credit quality should decline while its debt securities remain outstanding. If an issuer’s credit quality declines after issuance but before the debt securities mature, the capital value of the debt securities can be expected to fall.

This is just like holding shares. If a company’s earnings outlook deteriorates, then the price of its shares will fall.

The key difference though, in this case, is where you rank in the capital structure of the company. Where you rank in the capital structure will determine your expected loss on your investment should the issuer default.

If the issuer defaults and is eventually wound-up, shareholders can expect to be wiped-out but the holders of senior ranking debt may be repaid in full. Holders of subordinated debt and deeply subordinated hybrid notes may suffer varying degrees of capital loss.

The further down an investor ranks in the capital structure of a company, the more equity-like their investment becomes and the portfolio benefits of holding bonds/debt securities will be steadily eroded.

Furthermore, as a debt security moves closer to equity, more equity-like characteristics will emerge, such as the flexibility to suspend coupon payments. Suspended coupon payments may be cumulative and eventually paid or they may be non-cumulative and simply lost.

A practical demonstration of these credit risks comes from examining the performance of the ASX-listed debt securities indices compiled by Australia Ratings. The indices are accumulation indices and therefore take into account income from coupons paid, as well as changes in the capital value of the debt securities.

The indices are new, having been compiled from just the end of February this year, with a base of 100. As at the end of October, the value of the hybrid debt securities index had fallen to 95.47, providing hybrid investors with a total negative return of more than 4.5% over the period.

The subordinated debt securities index stood at 100.56, after have moved below 100 in September.  Subordinated debt securities investors have earned very little over the period.

Senior debt securities investors however, have been the winners showing a positive return of 4.94% as the senior debt securities index increased to 104.94. Thus, as risk aversion increased over the course of the year, returns to debt securities investors varied accordingly.

But to put this into perspective, think about the returns to shareholders over the same period. The S&P/ASX200 index stood at 5929 points at the end of February, and finished October at 5239 points, a loss of 11.6% excluding dividends paid over the period.

While returns to debt securities investors would have varied with changes in the credit quality of individual companies, Crown Resorts, Origin Energy and Woolworths come to mind, an overall increase in risk aversion over the period hit those securities lower in a company’s capital structure, the hardest.          

Under the ASX debt and hybrid research scheme, Australia Ratings has been engaged to rate listed debt securities. These ratings combine two very useful assessments for debt securities investors.

The first component of a debt securities’ rating is an assessment of the credit risk of the issuer and takes the traditional form of a credit rating ranging from ‘AAA’ in the case of the highest quality issuer such as the Commonwealth government, to ‘BB’ for issuers of intermediate risk.

The second component is a Product Complexity Indicator (PCI), which is colour coded to reflect where a debt security ranks in the capital structure of an issuer and the complexity of the terms and conditions that come with that. The PCI colours range from GREEN for simple senior ranking bonds/debt securities, to RED for the most complex and subordinated hybrid notes.

In between, subordinated debt securities with deferrable but cumulative coupons will typically be assigned a YELLOW PCI, while those with non-cumulative deferrable coupons will receive an ORANGE PCI.

A full list of the credit ratings and PCIs assigned by Australia Ratings to ASX listed debt securities can be found at www.australiaratings.com.