The great thing about fixed income investments is that they typically provide greater capital stability than equities, property or other growth investments.
But, just how secure and stable are we talking? In an environment of global uncertainty and volatility, it seems pertinent to ask.
Corporate bond stability
Not long ago we hosted a Bond Forum for advisers and the media in Sydney. Expert panellists joined us from BondAdviser, Challis Investment Partners, Morningstar and Ord Minnett. The Forum looked at the opportunities currently available in Australia’s fixed income markets.
One of the questions that came up was: how likely is a corporate bond issuer to default? In the challenging economic environment we currently live in, that’s a reasonable question. It’s not uncommon to see businesses struggle and even fail, so default risk is relevant. Whether bonds are generally stable or not is a related but different question to whether the issuer could default.
Corporate bonds: Key features
There are some key features of senior corporate bonds which differentiate them from investment grade issuers. These factors determine their capital stability:
- A corporate bond is a debt security – a loan to the company by you, the investor
- When you loan someone money – you expect to be paid back along with interest. The company cannot change the interest amount (the bond’s coupon), or the payment dates
- The face value of the bond will be repaid when it matures and the company can’t change the maturity date,
- On the day you buy a fixed-rate corporate bond (or XTB over it on ASX), the return you will receive (yield to maturity) is 100% known to you. This is due to the fixed nature of the coupon & principal payments and dates
- Only a default by the company can change this outcome (or if you sell prior to maturity).
Bonds are very different to equities
On the day I wrote this blog, Aurizon shares fell more than 7% on the back of sub-par financial results. The bonds didn’t budge, in fact they increased in price slightly. The poor financial results were not deemed worrisome in terms of Aurizon’s ability to pay its debts. The seniority of the bonds and the obligation the company has to pay its senior bondholders on time is why bonds are stable.
It’s important to keep in mind that corporate bonds are very different to the shares issued by the same company. The board of the company has considerable latitude to vary dividends or, indeed, not pay them at all. Also shares are perpetual, so there is no ‘principal’ to be paid back. As a shareholder you own part of the company. As a bondholder you are owed money by the company.
Share price vs Bond price
The factors that determine the price of shares include everything that can possibly impact the value of the business. This depends on every investors’ perceptions or opinions on the business, and their view on the future stream of earnings. Bond prices represent the present day value of the coupons and principal. They take account of the risk the issuer will not meet these payment obligations (credit risk).
Recently we have seen a number of examples of the share price of a leading Australian company falling quite sharply, with little or no movement in their bond price.
These situations are essentially very simple to explain:
- Equity investors have changed their view on the value of the business
- Bond investors haven’t changed their view on the company’s ability to keep paying the interest and principal.
Relative total returns performance of Qantas shares vs the average of the 3 Qantas XTBs when the share price fell 11% in April 2016.
Bonds are not all created equal
Of course, not all companies are equal when it comes to the ability to keep paying the interest and principal on their bonds. The credit ratings that are applied by major ratings agencies such as Standard & Poor’s, Moody’s and Fitch give some indication of the credit risk of that issuer. Banks and the largest ASX listed companies are a safer bet due to their stronger credit ratings. Lower ratings, but still investment grade (BBB- or above) indicate greater risk for which you’ll receive a greater return.
You can get a sense of this risk in the yield-to-maturity of same tenor (time to maturity) corporate bonds from one company versus another. In general, the company with the higher credit risk will trade at a higher yield-to-maturity (lower price).
Not all securities that are issued by a company are equal when it comes to credit risk. We’ve seen the ‘chalk and cheese’ differences between equity and debt, but many companies, banks in particular, have other securities that sit between senior debt and shares. In the event a company gets into financial trouble, holders of the senior bonds will be paid out first. This occurs before holders of subordinated debt and is followed by the various forms of hybrids and preference shares with Shareholders paid last. There may be nothing left after the senior bondholders get paid.
What is the likelihood of a corporate bond credit event?
Bonds are generally stable but what about that question of default that came up at the bond forum? How likely is it? Capital stability won’t mean much if a company suddenly had some major calamity and gets into very significant trouble. This is where the bond issuer defaulting becomes a very real possibility. While it’s not at all common for ASX 50 to 100 companies, it does happen and it can’t be ignored as a risk.
S&P publishes default probability stats on a regular basis. They are based on actual defaults globally of both investment grade and non-investment grade issuers. For example, the default probability they published for 3 year investment grade bonds was less than 0.3%. Longer dated bonds have a higher probability because the risk any company could collapse increases as you move further into the future.
In Australia, the corporate bond market is still relatively under-developed compared with the US and over-concentrated in very high-quality names. Defaults by investment grade issuers have been rare in Australia and we don’t have the same well-developed sub-investment grade, or high-yield bond market as the US.
Over the last 30 years, Babcock & Brown and Pasminco are the only 2 companies that defaulted and whose corporate bonds started life as investment grade (i.e. with a credit rating of BBB- or better).
The high profile defaults of businesses that took place in the wake of the GFC such as Storm, Gunns and Timbercorp did not have a credit rating or involve bond holders.
What about hybrids?
Thanks in part to the performance of some hybrids during the GFC, there is increasing evidence that investors and advisers now understand that hybrids can behave like equities at the time that you least want them to.
Specifically, if the issuing company gets into trouble, hybrids can convert into equities or have their call dates deferred – or both. The issuer can defer the income from a hybrid or not pay it at all. While you are compensated for these risks with a higher coupon rate, their price volatility means you have to monitor the capital price of the hybrid as well as the income.
High quality fixed income now easily accessible
Recent innovations, such as the introduction of XTBs, mean that high quality fixed income securities are readily accessible by investors on ASX.
XTBs provide access to 39 individual senior bonds of high quality names from among the top 100 ASX listed companies. This makes them a capital stable alternative to cash and TDs without the capital volatility of hybrids and equities. That number will grow to 50 and beyond and Starter Portfolios will be available shortly to make choosing easier.
In a world where volatility and uncertainty have become the new norm, capital stability and safety are undeniably more precious than ever. Yes, a corporate bond issuer can default, but no, the likelihood is not high, particularly among the investment grade issuers in the top 100 ASX companies. Will XTBs meet your pursuit of stability? I’d say yes.
- White Paper: Lower for Longer – Fixed income investing in a low rate world
- View our infographic: Your Guide to Corporate Bonds
- How hybrids compare to corporate bonds