Investing

Mind the Gap

  • 25.Sep.2019
  • Kylie Purcell,  finder.com.au

Why not all fixed income is created equal

With equity market volatility on the rise, billions of dollars are pouring into the fixed income space as people seek out “safe haven” investments. At the same time, many new ‘fixed income’ products are entering the scene. However, not all of them keep the core characteristics of fixed income – pre-determined interest payment and maturity dates.

Here’s the rub – fixed income products such as bonds and cash are generally considered to be among the safest investments you can make. Differences in how they’re ‘packaged up’ for investors can make material changes to their characteristics..

Understand the product

If you’re looking at  corporate or government bonds, there are many routes to choose from these days. Some of these include exchange traded bond units (XTBs), exchange traded funds (ETFs), listed investment companies (LICs), listed investment trusts (LITs) and managed funds. While any of these products may fall under the “fixed income” asset class they can have very different features, legal obligations and risk levels.

At one end of the spectrum for example, you have hybrid securities. In fact, many people have changed their view on which asset class hybrids belong to. Once thought of as fixed income, hybrids are now often included within ‘growth’ investments.

Part of the reason for this change of views is that whilst hybrids have some similarities to bonds, they carry far greater risks than regular bonds. Like bonds, hybrid securities pay interest for a specific period of time, but the payments and the date of payment are not guaranteed. In some cases, the companies issuing the hybrid security may decide not to pay investors for years or even decades after the pledged payment date. Payments are not cumulative, so that one payment missed may be never made. The only comfort a hybrid investor can take is that most don’t allow ordinary dividends to be paid on shares if the hybrid coupon is not paid.

With so many new products on the market, what constitutes fixed income is also becoming muddied. Typically, fixed income is considered ‘more predictable’ because you know your return on investment in advance. Assuming no default of the issuing company or bank, this is true for a term deposit, or cash management investment. It’s also true when you invest in individual fixed-rate bonds, whether trading over-the-counter or on ASX, through XTBs.

It’s not the same when you buy units in a bond ETF or managed fund. As you’re investing in a mixed bundle of bonds, it’s impossible to predict what returns you will achieve in the future. They offer greater diversification, but that comes at the expense of those core fixed income characteristics.

On the other hand, when you buy ASX quoted XTB units, you’re mirroring one specific underlying bond. You can still invest in a bundle of them as with an ETF, but as you are choosing what’s in your bundle you maintain that key characteristic of ‘predictability’ at the heart of fixed income investing.

It’s important for investors to consider which attribute is most important to them before deciding which product best meets their needs.

Understand what’s under the bonnet

Not all products are on the same playing field when it comes to transparency. For example, fixed interest funds and ETFs are rising in popularity, but how many investors actually know what they’re investing in?

When you keep your investment to specific individual bonds, you know what company or organisation you’re investing in, and you know the Yield to Maturity it will provide if you hold that investment to maturity. You also know the specific payment dates when coupon payments will be made. When you invest in a range of  bonds via a managed fund or ETF the bonds included change on a regular basis – some ETFs and funds contain hundreds of bonds and changes occur on a daily basis. This means keeping up to date with which companies you’re invested with becomes harder for the investor. The additional diversification has been gained at the expense of transparency.

While ETFs are required to publish their underlying holdings on a daily basis, LICs and some unlisted managed funds are only required to do so on a monthly basis, so investors may not know for sure what they’re buying. It’s critical that investors know how transparent their product is before diving in.

How easily can you exit?

When you invest in individual bonds you know the date of maturity – unless the company gets into financial difficulty you know when you’ll get back the face value of your investment. Remember, even when you’re investing in individual bond securities, if you sell before maturity, you do so at the current market price – this may be less (or more) than you initially paid.

And remember, the ease with which you can enter and exit your investment differs depending on what kind of product you’re using. For example, LICs and LITs can be difficult to cash in quickly because they’re close-ended products (there’s a fixed number) and less liquid than, say, exchange traded bonds (AGBs + XTBs) or bond ETFs. So, if you need to cash in quickly, you could be forced to sell at a loss if demand from other investors is low.

Whether you trade over-the-counter (OTC) or via an exchange (i.e. the ASX) may also impact how quickly you can enter and exit the market. Trading on the stock market can make it easier for investors to cash in or stock up. However, most corporate bonds are traded on the OTC market – which has less pricing transparency and is less liquid, so there may be fewer buyers if you need to exit a bond position quickly. You may not get the price you want.

Credit risk

It’s important to be aware that bonds themselves carry different levels of credit risk which are reflected in their credit ratings, if the company has one. A credit rating is given by rating agencies to mark whether or not a company or organisation is at risk of not being able to repay its debts.

For example, Australian government bonds will normally have the highest safety rating of AAA, while some corporate bonds will be rated lower at BBB or even to the lowest rating D. Bonds that have lower credit ratings usually pay higher interest to compensate for the risk.

If a company is ‘investment-grade’ it means that it has been classified as a low risk or relatively low risk investment, normally with a rating of between AAA to BBB- (medium).

Not all companies have a credit rating, this may not be reflective of the risks associated with the company. It may simply be that the company has never engaged a ratings agency in the past. Because they haven’t needed to do so, for example they may have only ever borrowed from a bank who does their own risk assessment or they have been able to issue bonds without the market requiring them to obtain a credit rating. In any event, ASIC licensing rules prevent specific credit ratings being published to retail investors.

Risk checklist

Of course, many fixed investment products are considered to be lower risk when compared to other asset classes, but it still pays to speak to a financial adviser before you take the plunge. If you’re considering investing in a fixed interest product, make sure you check off the following:

  • What are the assets?
    Managed funds, ETFs, LICs and LITs can track any number of assets, including bonds, shares, cash and property. For example, if you’ve invested in a fixed income fund, there may also be other riskier assets added to the mix. Always do your homework.
  • How easy will it be to cash in?
    What happens if you need your money back quickly? Will it take a long time and will you lose some of your investment in doing so?
  • What’s the credit risk?
    Government and corporate bonds may have a high credit rating (rated AAA) or a low credit rating (rated BBB-). While low-grade bonds, sub-investment grade with a credit rating of BB+ or lower, offer higher interest than high-grade bonds, they carry greater risk. Make sure you know which you’re investing in.
  • What happens if the issuer goes bust?
    Is the company obliged to pay you? How quickly will this happen?

 

 Disclaimer

The views of the author are not necessarily the views of XTB. The information in this article is general in nature. It should not be the sole source of information. It does not take into account the investment objectives or circumstances of any particular investor. You should read the PDS that relates to that Class of XTB prior to making an investment decision and consider, with or without advice from a professional adviser, whether an investment is appropriate to your circumstances. Australian Corporate Bond Company Limited is the Securities Manager of XTBs and will earn fees in connection with an investment in XTBs.

Events

  • 24Feb 2020

    YTMGP1: GPT 3.657% 24 AUG 2026

    This is the coupon date

  • 24Feb 2020

    YTMF12: AMP BBSW + 1.35% 24 MAY 2021

    This is the coupon date

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