Income investors are flocking to bonds to shore up income.
To put the demand into perspective, consider when global investment firm, KKR launched a high yield credit fund (ASX:KKC) in the second half of last year it was rushed by retail investors.. The fund was set up as a Listed Investment Trust, investing in two other KKR funds with a target net average yield of 6-8 per cent per annum.
KKR aimed to raise $200 million but the fund was upsized to $925 million to accommodate yield hungry investors and even then, some were scaled back.
A range of new funds such as a large issue planned by Neuberger Berman points to further growth this year.
Separately, after long absences, Coles and Origin Energy had successful issues in the over-the-counter domestic bond market. Qantas issued its first 10 year bond as did AusNet Services, Pacific National and Coles – a sign of confidence.
David Jones issued a $300 million, non rated high yield bond and Virgin Australia, also a high yield issuer, launched its first ASX listed bond.
Just last month, ASIC relaxed rules allowing opaque, actively managed ETFs to trade on the ASX. Fidelity and Janus Henderson are said to be looking to launch across investment classes this year.
Finally, in 2020, bonds look set to enter the mainstream with more prospects for domestic investors than ever before.
With so much on offer, how do you chose what is right for you?
My view is that it’s wise to hold a mix of investment grade and sub investment grade bonds (commonly known as high yield bonds), as is buying them through different channels.
Credit ratings and the determination of investment grade or below will help you gauge risk. According to S&P Global, in 2018, the global average cumulative default rate for a five year investment grade bond was 0.90 percent. For a sub investment grade bond it was 14.55 per cent, a massive difference in risk.
The high yield part of the market is very attractive. However if you are investing to offset risk elsewhere, sacrifice some yield and limit high yield bonds to 20-30 percent of your bond allocation.
Aggressive investors might hold 70 per cent or more in high yield, but I’d expect them to be very wealthy and be able to afford significant losses or very conservative in the rest of their portfolio.
Allocating to bonds across the spectrum has advantages. Last year, the lowest risk government bonds outperformed given declining interest rates. Funds in this space reported double-digit returns for the 12 months to 30 November 2019.
A recurrent theme has been the chase for high yield. High yield means high risk and it’s important to determine and be comfortable with the risks before you invest.
It’s much easier to come to terms with the risks when investing in an individual bond. Investors would understand that a BHP bond is much lower risk than by Virgin Australia at the equivalent capital structure level.
But the further you get away from the actual investment and here I mean when you invest via a structure, the more difficult it is to judge the risk and return on offer. A reliable sign is the expected yields. A big fat return means big fat risks. Ask yourself why you are being paid?
Lets take the KKR credit fund. It’s targeted yield is higher than the ASX average dividend yield at just over 4 per cent per annum and around double what you might expect for low risk investment grade bond. I expect investors are being paid for possible illiquidity a heightened chance of non payment and eventual loss.
Clearly, the fund isn’t a defensive investment!
Adding bonds to your portfolio is generally a good move given reliable income and improved diversity. But it’s vitally important to understand what you are investing in and the structure if it’s a fund.
Direct investment through a broker is an optimum, you get to choose which companies to invest in, the term until maturity, the risk you are prepared to take and the yield. There are a small number of bonds available direct on the ASX. Brokers that can trade in the over-the-counter market require minimum amounts per bond and overall minimum investment amounts of $250,000 or more.
One of the main attractions with a bond is that they repay $100 face value at maturity. You never have to decide to sell!
But, investing via an ETF or fund means you lose this important feature. The fund merely invests elsewhere. Don’t underestimate this advantage, it allows you to plan for future major cash flow events by buying bonds that mature just before you need the funds.
Investing via a fund has advantages, especially if you are a novice to the bond market. A passive index linked ETF may invest broadly offering exposure to a range of investments. While an actively managed fund has greater potential to outperform and earn double digit returns, but may be more expensive and won’t necessarily replicate past performance. Please do your own research.
Originally published in The Australian, 28 January 2020 under the title “Returns and Risk – Weighing Bond Funds Versus Traditional Bonds”