Investing

Building a portfolio of XTBs

  • 04.JUL.2016
  • Richard Murphy,  XTB

Part 5 of our 6 part fixed income educational series: Constructing a corporate bond portfolio using XTBs

5. Building and buying a portfolio of XTBs

The last few articles in our series explored the world of corporate bonds and XTBs and the defensive impact they can have on your portfolio. In addition to their defensive role, corporate bonds and XTBs deliver predictable and capital stable returns. These returns can be higher than many Term Deposits, without the volatility of equites and hybrids.

Now we turn our focus towards how to select XTBs from the broad range available. Before starting, knowing your requirements is important, so you need to think of questions like:

  • What income do I need?
  • When do I need it?
  • What are my outgoings? (so you can match your investment income against your cash outgoings)

Earlier in thie series we learned that a key aspect of corporate bonds and XTBs is the predictability of income and capital repayment they provide. This gives you the ability to plan ahead. Subject to the bond issuer meeting its payment obligations – you know the income you’ll receive, when you’ll receive it, and when the capital will be returned – on the day you invest in bonds or XTBs over them.

Choosing from the range of XTBs

With almost 40 fixed & floating rate XTBs on ASX there are plenty to choose from. The range will only keep growing.  But how do you choose between XTBs, or choose a portfolio of them?  It can be somewhat daunting if this is your first time.

Do you just choose the XTBs with the highest yields?  

Some people adopt this approach. Probably because the bond issuers are all investment grade, therefore investors see them all as being a low risk of default.

While seeing this as low risk is a reasonable perspective, it is not a zero risk.  The risk of non-repayment by bond issuers is called Credit Risk.  Qantas XTBs, for example, have a higher yield than NAB XTBs, because NAB has a higher credit standing.  Generally, higher yield also means higher risk.

What about the time left to maturity when the principal is repaid?

This could be 18 months for one XTB and 6 years for another. Lending someone money for a short time is less risky than lending it to them for a long time.  You have interest rate risk (mainly for fixed-rate XTBs).  If rates rise in the future, the price of fixed-rate XTBs will fall. If rates fall as they did in May 2016, the price will rise.  The longer dated the XTB, the greater the sensitivity of its price to interest rate changes. Its important to remember that if you intend to hold an XTB until maturity, it does not matter whether rates go up or down. You will be paid back the principal and earn the return (the yield) you bought them at, assuming there is no default.

How interest rates affect corporate bond prices and coupon payments

XTB investors need to be aware of these broad sensitivities.  From your perspective, it may be that ranking them by yield and picking the top XTBs is the way to go. But, you need to be aware of the trade-offs using this approach, as well as comparisons you should make with other XTBs and other investment types before you or your adviser make a decision.

Factors to consider when choosing XTBs

This information is very general in nature and should not be taken as personal advice as we do not know anything about your specific circumstances.  It is intended to be a guide to help you choose. The Responsible Entity and Manager of XTBs recommend you consider seeking specific advice from your financial adviser before making any investment decision.

Building an XTB portfolio

The predictability of the final outcome of an investment in XTBs (particularly fixed-rate XTBs) is an excellent feature for building portfolios.  At the time you invest you know:

  • The exact income rate and amount you’ll receive (floating-rate is less exact, but you know the formula),
  • Exactly when you will be paid back,
  • Precisely how much you will be paid back,

On the day you invest, you know the return you will get if you hold to maturity (assuming no default by the bond issuer). It’s the yield you bought at.

There aren’t many investment options that provide this same level of clarity up front. This is one of the key attractions of individual fixed income securities over many funds and ETFs.

The starting point: The universe of XTBs – the building blocks of your portfolio

A very simple approach to portfolio construction is to rank by yield and select the top yielding XTBs. The top 8 XTBs by yield make a portfolio with an average yield of 3.96%.

ASX CODE BOND ISSUER MATURITY DATE COUPON TYPE COUPON P.A. IND. YIELD
YTMAWC Alumina 19 NOV 2019 FIXED 5.50% 4.539%
YTMDO1 Downer 11 MAR 2022 FIXED 4.50% 4.229%
YTMQF3 Qantas 19 MAY 2022 FIXED 7.75% 4.098%
YTMAZJ Aurizon 28 OCT 2020 FIXED 5.75% 3.971%
YTMQF2 Qantas 11 JUN 2021 FIXED 7.50% 3.971%
YTMLL1 Lend Lease 13 MAY 2020 FIXED 6.00% 3.783%
YTMQF1 Qantas 27 APR 2020 FIXED 6.50% 3.658%
YTMIPL Incitec Pivot 21 FEB 2019 FIXED 5.75% 3.458%
Data as at 27 May 2016

This approach just looks at yield and doesn’t take any other factors into account.

It is worth noting that with 39 XTBs there is a wide range of available yields.  Longer dated bonds usually have higher yields than shorter dated bonds of the same credit quality (you should expect more for lending money longer term).

But should you just pick the top 8 from the list ranked by yield, or should you also consider other filters? This is a matter of choice.

Diversification

The more XTBs you include in your portfolio, the more the overall yield moves towards the average of the universe of XTBs.

But how many bonds gives you enough diversification?  This is a matter of opinion rather than fact.  Many advisers would consider that unlike equities, you don’t need to cover all industry types to get appropriate diversification. Some fund managers would argue you need lots of bonds to get proper diversification, but they also argue you need hundreds of equities to be diversified, yet people often own smaller portfolios of equities.

Fund managers make money by diversifying so they have one view, whereas there has always been an investor appetite in Australia for holding individual securities directly.

Corporate bonds are loans to a corporate. If two companies have the same credit standing, then your credit risk is very similar irrespective of industries.  For example, if Woolworths and Telstra had the same credit rating, then you could consider their bonds (of the same term) as comparable, so you may not need both.  Whereas their equites are fundamentally different and you may need both.

Therefore, many commentators consider 5-10 bonds as providing enough diversification for most investors, compared with say 15-25 equities needed to cover industries and sectors.

In this section, we have focused on constructing a portfolio of 8 XTBs to give you a sense of a reasonably diversified portfolio.

Adding filters to your portfolio

1. Credit risk filter

Starting again with the universe of XTBs ranked only by yield, you might be concerned with being over-exposed to any single bond issuer.  A basic filter would be to have only one XTB per bond issuer in your portfolio. This could be called a credit risk filter. This removes 2 of the 3 Qantas XTBs, and 1 of the 2 Downer XTBs. The result is a portfolio with 8 XTBs with a 3.87% YTM.

ASX CODE BOND ISSUER MATURITY DATE COUPON TYPE COUPON P.A. IND. YIELD
YTMAWC Alumina 19 NOV 2019 FIXED 5.50% 4.539%
YTMDO1 Downer 11 MAR 2022 FIXED 4.50% 4.229%
YTMQF3 Qantas 19 MAY 2022 FIXED 7.75% 4.098%
YTMAZJ Aurizon 28 OCT 2020 FIXED 5.75% 3.971%
YTMLL1 Lend Lease 13 MAY 2020 FIXED 6.00% 3.783%
YTMIPL Incitec Pivot 21 FEB 2019 FIXED 5.75% 3.458%
YTMAST AUSNET 28 JUN 2022 FIXED 5.75% 3.444%
YTMAGL AGL Energy 05 NOV 2021 FIXED 5.00% 3.424%
Data as at 27 May 2016

This approach still focuses on the higher yielding XTBs, but it also removes some credit risk to issuers that appear more than once.

2. Maturity profile filter

Many investors want to be able to choose investments that allow them to plan their future income to match their future outgoings.  It’s called ‘outcome based investing’. The highly defined and predictable nature of bonds and XTBs provides for this type of investment behavior.

By selecting an 8 XTB portfolio so that 1 XTB matures per year, you get a portfolio with both capital and income payments each year. This can provide investors with the income versus outgoings pattern they are looking for.  

Filtering by maturity is also called ‘laddering’. We’re still selecting the XTBs with the highest yields, but with the laddering overlay.

Note: With this approach, you would need to replace one XTB each year as they mature to keep the portfolio rolling forward.

In the XTB portfolio below, approximately one XTB per year matures for an average Yield of 3.58%.  

ASX CODE BOND ISSUER MATURITY DATE COUPON TYPE COUPON P.A. IND. YIELD
YTMF02 BOQ 07 NOV 2016 FLOATING BBSW+1.15% 3.123%
YTMCWN Crown 18 JUL 2017 FIXED 5.75% 2.453%
YTMDOW Downer 29 NOV 2018 FIXED 5.75% 3.425%
YTMAWC Alumina 28 OCT 2020 FIXED 5.75% 3.971%
YTMAZJ Aurizon 11 JUN 2021 FIXED 7.50% 3.971%
YTMSG1 Stockland 13 MAY 2020 FIXED 6.00% 3.783%
YTMQF2 Qantas 27 APR 2020 FIXED 6.50% 3.658%
YTMDO1 Downer 21 FEB 2019 FIXED 5.75% 3.458%
Data as at 27 May 2016

3. Yield vs Maturity filter

Longer-dated XTBs generally having higher yields, but also higher interest rate risk (for fixed-rate XTBs).  So, how do you select a portfolio that maximises yield and minimises interest rate risk?

You can’t have the absolute best of both worlds simultaneously, but it is possible to generate a portfolio with the maximum yield you can get for the minimum term to maturity.  A Yield vs Maturity pay-off.

The quick way to do this is look at the out-performance of each XTB’s yield over the cash rate which can be done with a simple formula

XTB YTM – Current RBA Cash Rate (1.75%)

————————————————————–

Term to Maturity

Then you can rank the results of that calculation as shown in the table below.

This gives you a very different portfolio with an average yield of 3.14%.  The average life is shorter as the XTBs with maximum yields for minimal term, come to the fore.

ASX CODE BOND ISSUER MATURITY DATE COUPON TYPE COUPON P.A. IND. YIELD
YTMF02 BOQ 07 NOV 2016 FLOATING BBSW+1.15% 3.123%
YTMCWN Crown 18 JUL 2017 FIXED 5.75% 2.453%
YTMBHP BHP 18 OCT 2017 FIXED 3.75% 2.383%
YTMMG1 Mirvac 18 DEC 2017 FIXED 5.50% 2.661%
YTMLLC Lend Lease 13 NOV 2018 FIXED 5.50% 3.057%
YTMDOW Downer 29 NOV 2018 FIXED 5.75% 3.425%
YTMIPL Incitec Pivot 21 FEB 2019 FIXED 5.75% 3.458%
YTMAWC Alumina 19 NOV 2019 FIXED 5.50% 4.539%
Data as at 27 May 2016

Events

  • 21Sep 2017

    YTMWOW: WOOLWORTHS 6.00% 21 MAR 2019

    This is the coupon date

  • 28Sep 2017

    YTMWES: WESFARMERS 6.25% 28 MAR 2019

    This is the coupon date

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