Bond basics: Getting to know the risks and returns

March 17 2016
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Fixed income investments can provide investors with stable and regular income. However, not all fixed income investments are created equal.

Fixed income generally provides investors with more secure and stable investments than equity, property and other growth assets.

But not all fixed income investments are equal. Capital stability is a hallmark of fixed income. Some fixed income investments may appear to be fixed income, but they’re a mixture of debt and equity, so they tend to lose this capital stability.

It all comes down to its ranking in the ‘capital structure’. The higher the ranking, the lower the risk. If there’s a default, higher ranking investments get repaid first. This lower risk could mean lower returns.

The lower the ranking in the capital structure, the greater the risk and the potential return. Lower ranking securities are generally more volatile, which can have a negative impact on your ability to sell your investment without loss.

If capital stability is important, you need to understand that the income on equites or hybrids comes with a higher price volatility than bank accounts or bonds. Investors need to be aware of this trade-off.

Understanding the capital structure

Practically speaking, the most senior bank investments are term deposits (TDs), which sit at the top of the capital structure, and then senior bonds. In a default, the bank will pay TDs first, then its senior bonds.

Subordinated bonds are next in the capital structure, with some traded on ASX. These are being phased out because APRA have adopted new global standards designed to prevent banks getting into another GFC. They will be replaced by a new style of subordinated notes that have more equity features.

Many financial advisers see the new style of subordinated notes as hybrids. APRA calls them Tier II Hybrids, sitting above Tier I Hybrids, which are next to equity at the bottom of the capital structure. Both types of hybrid are designed as a buffer protecting banks. It’s the bank that’s protected – not you. Your investment is the buffer. APRA, and not management, has the ultimate say on whether or not these Hybrids can be redeemed or are required to be converted into riskier equity securities.

The highest risk is equity, which may get nothing in a collapse but receives all the upside.

Diversification is key

Investments should be diversified, with a mix of equity and fixed income.

Your equity gets the upside for taking the greatest risk. TDs and bonds are essentially loans that get paid back with interest, but without any great upside. Both types of hybrids are in the middle – income securities without the upside of equities. They may be paid back by the issuer, or converted into equity to help the issuer avoid trouble.

To be fair, most hybrids have been ‘called’ (paid back), but it’s not like a bond where the bank must pay you back. It’s also an option the regulator has to approve, taking the bank’s health into account each time. You shouldn’t see being paid back as a sure thing. The new global standards require that it isn’t.

The position in the capital stack has consequences for capital stability. TDs and corporate bonds are more stable and equities and hybrids are more volatile.

The arrival of corporate bonds

A big change in Australia’s markets is that it’s now easier for SMSFs to invest in the performance of senior corporate bonds, which aren’t really traded on ASX. They mostly trade between banks and fund managers in large parcels often too much for SMSFs.

SMSFs can now access senior bond returns through XTBs (exchange traded bond units). XTBs are on the ASX and can be bought in $100 sizes.

Each XTB has the returns of a particular bond. If a Telstra bond matures in five years, so too will its Telstra XTB – 100 per cent of the interest and principal is passed to XTB investors.

Corporate bonds bring a number of advantages to diversified portfolios. Capital stability, which was discussed above, is a key one.

XTBs provide steady and predictable income that may yield more than government bonds, TDs or cash management accounts.

What are the main risks?

Corporate bonds are typically high-quality investments with a low level of risk. But there are a few things to keep in mind.

There is a risk the bond issuer could fail. XTBs can cover investment grade issuers, but this risk shouldn’t be ignored. The bonds backing XTBs are held in an ASX-quoted trust, and its responsible entity looks after investor interests.

Interest rate changes are another risk. If the RBA lifts rates, fixed coupon bond prices fall. If they drop rates, fixed coupon bond prices rise. Floating rate bonds are not affected in this way.

Fixed income plays an important role in generating regular income with strong capital preservation. Incorporating bonds into portfolios is a great way to safeguard your retirement savings and defend against equity downturns.

Richard Murphy, chief executive, ACBC

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