Investing

Probability based investing

I view XTBs as a buy and hold investment, therefore the investor’s focus is usually around cash flow profiles and issuer profiles. However, many investors also wish to consider what their portfolio may look like after a year. The liquidity of ASX products like XTBs makes this a valid approach.

For a one-year horizon, an approach I adopt is a simple probability weighted style of investing.  Many of us use this method intuitively, but XTBs are particularly suited to the approach using the sensitivity analysis we covered in last week’s Yield Matters.

How I apply this approach

There are three main steps to this approach:

1.       I define three outcomes and give each of these a probability

2.       I then multiply the Total Return of each outcome by my probability

3.       By summing the probability of weighted outcomes, I have estimated a probability adjusted investment return.

How does this work in practice?

Let’s use YTMQF3 as an example.

Step one: Defining outcomes and allocating probability

YTMQF3 Total Return calculated using three different yield to Maturity (YTM) scenarios

  • If YTM falls by 0.50% – 1 year Total Return = 6.23%
  • If YTM stays the same – 1 year Total Return = 4.16%
  • If YTM rises by 0.50% – 1 Year Total Return = 2.15%

I then give a probability to each outcome.

Firstly, assume I am bullish and believe rates will stay “lower for longer”. For this example, I will use the following probabilities.

  • YTM falls by 0.50% – a 60% chance of happening
  • YTM stays the same – a 30% chance of happening
  • YTM rises by 0.50% – a 10% chance of happening

Step two: Multiply total return by probability

Table A: Bullish view – Lower for longer

Change in YTM Total Return* Probability of outcome Weighted Outcome
-0.50% 6.23% 60% 3.74%
0.00% 4.16% 30% 1.25%
+0.50% 2.15% 10% 0.22%
Weighted Total Return of YTMQF3 5.20%

But what if I believed that the YTM of each XTB was set to rise?  Then the result could look like Table B.

I call this the ‘risk-on’ scenario.

Table B:  Risk-on scenario

Change in YTM Total Return* Probability of outcome Weighted Outcome
-0.50% 6.23% 10% 0.62%
 0.00% 4.16% 20% 0.83%
+0.50% 2.15% 70% 1.51%
Weighted Total Return of YTMQF3 2.96%

Step three: Portfolio construction

I ran the first two steps for all 33 fixed-rate XTBs to see how each XTB performed in the different scenarios.  Longer dated and higher coupon bonds do better in the lower for longer world.  Shorter dated and lower coupon bonds do better in a risk-on world. Using the lower for longer scenario a four XTB portfolio could be:

XTB Code Weighted Total Return*
YTMAWC 5.54%
YTMDO1 5.41%
YTMQF3 5.20%
YTMAZJ 4.82%
Weight Total Portfolio Return 5.24%

However if I assume a “risk-on scenario” the portfolio could be:

XTB Code Weighted Total Return*
YTMAWC 4.30%
YTMAZJ 3.16%
YTMQF2 3.15%
YTMIPL 3.10%
Weighted Total Portfolio Return 3.42%

The comparison between ‘lower for longer’ and ‘risk-on’ portfolio are:

  • YTMQF3 is replaced with YTMQF2
  • YTMD01 is replaced with YTMIPL
* Data as at 10 June 2016

A note on my approach

The actual outcome for total return will not be a blend of any different outcomes. In the end there is only one result – that which actually happens.

The approach I take is to try to quantify a client’s view on markets to make an appropriate portfolio selection.

There are many risk features that will change an XTB’s YTM (as discussed last week).

In this article, I actually assume an XTB’s YTM changes. An XTB may not track the movement of what a client considers to be interest rates.

Probability based investing: Why I do this?

I find overlaying this approach to a portfolio gives clients an appreciation of the sensitivity of XTBs and overcomes the belief that fixed rate securities are only for a high interest rate environment or a falling rate environment.

Fixed income can be an asset for all environments, if portfolios are constructed carefully.

Here to help you and your clients

We are committed to giving access, transparency and liquidity to investors. We also believe that investors should have fixed income securities like XTBs in their portfolio. We are pleased to work with advisers to deliver a quality fixed income solution to their clients.

If you would like to discuss your client’s requirements with Ian, please contact your XTB Regional Manager to arrange a convenient time.

Ian Martin

Ian Martin, is Co-Founder and Director of Australian Corporate Bond Company. Read more about Ian

 

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