Not all bonds are created equal
This article appeared in the January 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
In seeking yield, don't overlook the risks of unlisted bonds.
By John Likos, Morningstar
Morningstar is becoming increasingly concerned that investors are buying unlisted bonds without looking behind the yield to understand the risks that come with these securities and whether those risks are appropriate for their investment profile.
This article aims to help investors understand some of the key risks of purchasing unlisted bonds and the essential questions to ask. It also lists alternative options for exposure to the fixed-income asset class, which we believe are often more effective in providing attractive yield without undue risk, relative to direct unlisted bond holdings.
(Editor's note: To learn more about the features, benefits and risks of bonds quoted on ASX, and interest rate securities, take the free online ASX Bonds and Hybrids course.)
Because interest rates remain low, investors continue to seek yield, often captivated by headline returns without regard for the accompanying risks of those investments. Recent strength in bond markets is creating a sense of overconfidence in navigating bond risks, which have been subdued in a favourable global environment of low interest rates and high liquidity.
At the Morningstar Individual Investment Conference in Sydney in October, several investors highlighted their concerns about the unlisted bond market. It became apparent that many were not aware of the risks that came with investing in these securities.
Here, we identify some of these key liquidity and credit risks. ASX Investor Update readers can download Morningstar's full report on this topic (after registering for a four-week trial). Always remember that, in most cases, the higher the return, the higher the risk.
Overview of the Australian bond market
The Australian bond market is made up of various types of securities, including those issued by the Commonwealth Government, state and territory governments, covered bonds, non-financial corporate bonds, financials bonds, bonds issued by foreign borrowers (referred to as kangaroo bonds) and various types of asset-backed securities.
We are excluding hybrid securities from this analysis because we do not consider them part of the traditional fixed-income asset class. Hybrid securities are a unique asset class, having debt and equity characteristics, whereas fixed income comprises pure debt securities.
Australia's bond market has continued to develop in line with the needs of regulators, investors and issuers. Diagram 1 below highlights the evolution of the market over the past 20 years.
Diagram 1. Bonds on issue in Australia
Source: ABS; RBA
These charts provide some interesting insights into the Australian bond market, in particular:
- The market continues to grow and attract both domestic and foreign issuers.
- The market represented about 98 per cent of gross domestic product in December 2013, compared with 84 per cent in June 2007.
- Public sector issuance has been the dominant contributor to bond growth since 2007, driven by state and federal governments funding their budget deficits.
- Issues by financial services companies have fallen from their recent peak as a consequence of banks utilising their growing deposit funding base and slower lending growth.
- Asset-backed security issuance, which is largely made up of residential mortgage-backed securities, decreased sharply between 2007 and 2013 but showed signs of recovery during 2014.
- Kangaroo bond issuance has increased significantly as overseas issuers look to diversify their funding into the Australian market.
Unfortunately for retail investors, the overwhelming majority of bonds are issued to wholesale clients, where subsequent trading is undertaken over the counter, as distinct from being listed on ASX. Listed direct bond investment options are limited for investors, mainly being Australian government bonds that can be bought or sold the same way shares are traded.
Liquidity risk, in this context, refers to the ability to buy or sell a bond on a timely basis at a fair price. Low levels of liquidity make it difficult to buy or sell a bond, raising the risk of having to buy at an inflated price or sell at a capital loss. Although investors may purchase bonds with the intention of holding to maturity, a situation may still arise where these positions need to be sold, therefore investors should always be aware of the illiquidity of their investments.
There are many indicators of liquidity in the bond market, including the bid-ask spread, issue size, number of market makers and whether the issuer is a public company or not. We have a preference for bonds that display a narrow average bid-ask spread, are part of a larger issue size, are issued by publicly listed companies with continuous disclosure requirements, and are traded in a market that has a market maker. We acknowledge it may be difficult to obtain all these features, but the more of them the bond has, the better.
Credit risk refers to the risk that the borrower, or bond issuer, defaults on a payment, such as a coupon or principal payment. An investor is essentially lending money to an issuer, so investors need to assess the issuer's ability to make timely distribution payments and return the principal on maturity.
Credit risk is best assessed via credit analysis of the issuer and the bond in question. Unfortunately for many investors, this is beyond their expertise, so an alternative is needed. We recommend utilising Morningstar's independent equity research as a starting point to understanding the profile of the issuer.
Unlisted bonds present a quandary for retail investors in that it becomes difficult not only to assess how risky they are, but also to derive a relative valuation by comparing them to other bonds. For this reason, it becomes critical to undertake research on the investment and cross reference the findings with Morningstar's research.
We recommend retail investors read Morningstar's latest research on issuers, taking particular note of the stewardship rating, uncertainty rating and whether or not there is an economic moat. Morningstar's through-the-cycle methodology is particularly useful to gain an insight into the long-term prospects of an issuer.
ETFs and managed funds as alternatives
Options for investors to get exposure to fixed income include listed alternatives, exchange-traded funds or ETFs, and managed funds. Morningstar provides independent research on several managed funds and ETFs with a fixed-interest focus.
About the author
John Likos, CFA, is an analyst in the credit research team at Morningstar, a leading global provider of independent investment research. He has more than 10 years of credit experience in Australia and Europe.
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