Aiming high for added returns

Fixed interest has an important place when building a diversified portfolio, and the recent rise in new high yielding investment vehicles, such as hybrids and structured products, highlights a new financing window for feeding voracious appetites.

According to a report by Principal Global Investors, high yield enhanced products are here to stay. “Four permanent long-term changes have helped transition the high yield class from a timing instrument to a core holding — increased investor diversification, market growth of the high yield market, historically uncorrelated performance, and improvement in credit risk management tools.”

Defining high yield

Tony Rumble, who spearheads the syndicate of advisers who packaged the successful Alpha Notes, points out that while critics talk about the complexity of these tools, it is a natural part of innovation. But for investors seeking out these products, and for some advisers who are asked to assess them, there is still some confusion and doubt.

Vincent Lo Blanco, director fixed income and cash at Merrill Lynch Investment Managers, says that even the term ‘high yield investments’ can be misunderstood. “The universal view is that it depends upon rating rather than the yield. Securities that have ratings from AAA to BBB are investment grade, and below BBB are high yield.

“They used to be known as junk bonds, but they are now called high yield. In the current environment, a high yield is 2 per cent or more above bank bills, but there’s times when the spreads are wider.”

He adds: “Generally, it [high yield investment] may not have a rating, and it may have a structure that will split off different risk levels and different credit ratings. So the return should be consistent with that.”

Lo Blanco says investors should always understand that there is no upside, only a downside — on the principle that if a company collapses, then they may lose 100 per cent of their investment.

“In relation to the probability of default, investment grade companies hang around for a long time. Once you go below that, you are stepping up in risk, although you are getting more return. That’s important to remember.

“Diversification within a debt portfolio is a more powerful principle of portfolio construction than for an equities portfolio.”

While the Australian Securities and Investments Commission (ASIC) issued a report earlier this year that warned investors about the high risk nature of debentures, there is a renewal of interest in the high yield market post 2003, given the low interest rates, stronger company performances, and reduced liquidity concerns about corporate refinancing.

Principal Global Investors also says a poll of dealers in the US reflects a general feeling that steady demand, light supply, continued upgrades, and very low defaults will keep the market firm in 2005. In turn, investors have been bombarded with new securitised products.

New products

One product in the new wave of structured credit products is collaterised debt obligation (CDO), which is a portfolio of debt (such as bonds, loans, credit default swaps) that is split into different tranches and sold to investors. It is not a corporate bond, and it depends on the tranche as to how secure you are on default.

Alpha Notes Series 1, offered by a special purpose investment vehicle, are typical of this breed, and were well-rated by Aegis Research when they opened and closed earlier this year. The deal involved a relatively small raising of $50 million, paying a margin of 2.5 per cent above the 90-day bank bill rate.

It is also a first for being packaged by a syndicate of advisers and backed by ABN Amro. This same group is launching a capital guaranteed commodity investment shortly.

Rumble, also of the Savings Factory, points out that self-managed super funds (SMSFs) and high nets — two groups that love high yield products— are quite demanding, and the advisers who work with these client types need to spend just as much time on the investment side as on the planning side. “Once they start to work on analysing investments, their skills have to increase, and that’s a good thing.”

He adds: “Hybrids are fantastic, and probably the start of advisers getting into enhanced yield securities. Five years ago, they were seen as too complex, but now they walk out the door. So what’s difficult today may be seen as fairly orthodox tomorrow. And that’s encouraging advisers to move into this space … it’s really just about innovation.”

Reduced investor risk

Another group promising a traditional-style debenture product with supposedly fewer headaches is Renaissance Fixed Income Limited, distributed through FIIG Securities. Jim Stening, managing director of FIIG, says the product offers investment in fixed interest investments and Australian Prudential Regulation Authority (APRA)-regulated authorised deposit-taking institutions (ADIs). It pays 40 basis points over the bank bill swap rate benchmark (BBSW), giving a headline yield of 6.25 per cent per annum at present.

“It’s an exposure that’s simple. There’s a lot of money in short-term investments in Australia, so people are comfortable with those types of products. Renaissance debentures provide flexibility, with a range of the payments and terms,” says Stening.

Ninety per cent of Renaissance’s investments are either investment grade or capital guaranteed by an APRA regulated institution. There are no fees payable by investors.

Stening says: “Fixed income is a conservative class, and the mantra should be about capital and income security.

“What’s really disturbing is that there’s a number of products coming in which don’t really qualify under the ‘fixed interest’ label’.

“It’s really high-risk products offering a high yield headline being dressed up as fixed interest. If you’re building a balanced portfolio, then you should only have a small amount in those assets, and that’s why Renaissance only has 10 per cent of its holdings in un-rated products, because those high yielders can contribute to a competitive return.”

Access to the wholesale market

What other problems beset fixed interest investing? Rob da Silva, managing director, Asia Pacific fixed income at Principal, agrees that if you want to invest as an individual in the high yield sectors, you can’t get to the wholesale market easily unless you have $500,000 or more. In other words, buying bonds direct is not possible.

“The CDOs [collateralised debt obligations] have been a way to allow access to some parts of the market. But the flip is spreading your risk and understanding that risk … so really, for the individual to get a realistic approach, you can go to funds.”

Principal’s global income fund invests in high yield, is hedged to Australian dollars, and is available on platforms such as BT. “A standard bond fund will be eaten up by fees, but in our case we’re targeting 300 basis points over the UBS bank bill index over three years … so even after fees, you’re generating a competitive return.

“It is a lower returning class, so fees are a more significant feature. A strategic income fund is designed to be ahead of the cash rate … over 14 months it’s definitely delivered that.”

Warnings

AMP’s economist Shane Oliver says he is still concerned about hybrids. “You need to put effort into determining the return, which is largely linked to the risk of the borrower.”

Oliver says the main risk is that inflation could increase and you would subsequently try to sell your bond before maturity. “In corporate debt, you have the credit risk of borrower defaulting … and that’s why people rely on the rating agencies to provide a guide on the default risk, and the other risk is that there could be a blow out in yields, for instance, you buy a portfolio and inflation takes off or companies go bust.”

For example, when US General Motors and Ford were downgraded to junk status, and the yields on their debt blew out in May this year, investors offloaded it so the gap on the yield went 2 to 3 per cent above US Treasury bonds. Oliver says: “This affected the whole market, and there was a blow out in spreads, but it was largely contained.

“Since then, it’s reversed to some degree and the yields have come down, so the price has gone up. US investors who bought into corporate debt funds would have had a capital loss in May but recovered, and some hedge funds would have got into trouble with that too. It also affected some investors here, but marginally … it’s a salutary reminder of the risks of credit rating.”

Hybrid securities

The rocket ride of hybrid securities in Australia began with the first issue by Adelaide Bank in 1998. A hybrid security is based around the ownership of a tradeable preference share in the company with a coupon. The advantages are three-fold — potential yield, liquidity, and the chance to make a capital profit on the trade.

For example, David Jones Reset Preference Shares issued in 2002 at $100 have paid a regular franked dividend of 8.1 per cent, and is currently trading at around $1.55 to $1.65.

Barry Zeigler, financial consultant, fixed income at Citigroup Wealth Advisors, says hybrid securities make a great substitute for retail investors seeking the characteristics of fixed income investment without the illiquidity and riskiness of some debentures. However, investors should always seek independent advice when considering making any decision.

He explains: “If you’re comfortable with the underlying company, then you should be comfortable with the underlying security — 65 per cent are issued by banks or insurance companies, which has to be better than a debenture secured by a rogue property developer.

“However, it may not be so favourable if the interest rates fall, or there’s an issue with the underlying company, such as when Multiplex had a sudden risk downgrade following the Wembley Stadium announcement hit.”

Meeting client demand

Mostly, banks and top 200 companies issue tradeable preference shares, and there’s a heavy demand for new issues. Berkley Group’s Jim Clegg agrees that these types of securities appeal to his clients because of the certainty of high yield and potential capital gains. Clegg says his clients have 70 per cent of their portfolio in direct investments, so there’s already some understanding of the underlying equities market. “In all cases, income and capital rank ahead of equity. So it gets back to evaluating the company.

“We had people in Multiplex SITES, which was awful, but it was never seen as an insolvency event and they have now recovered … that’s been our worst this year. On the other side, TAPS issued by Hastings, owned by Westpac, is paying 2.1 per cent ahead of the 90 day bank bill rate, and a fair proportion is tax deferred.”

He adds: “If you want to talk high yield, look at shares 10 years ago and then work out the dividend as a percentage of what you paid — it’s in excess of 20 per cent fully franked … so grossed up it’s looking like 30 per cent as a percentage of purchase price.”

Yet, in comparison, people are still getting the same yield on their debentures over five years, he says, with no capital growth. “You need to differentiate between the need for yield now and the need for yield later. The yield on good quality shares will grow over time … so that’s the primary consideration in assessing the client asset proportion.”

Importance of diversification

Eric Smith, chief investment officer, Vanguard Australia, warns that there’s no free lunch on the structured products. “Bond funds have been around for a long time because of defensive needs, but we’re seeing a rapid increase in more structured products. Our view is that people need to be more careful.

“There’s one free lunch if you elect to opt for a diversified basis … whereby you lower the risk by not exposing to only one. The structured ones give a higher return, but there’s higher risk, and if that return is dependent on a structure that has a single name backing then you’re exposing yourself to that … it’s like buying a bond.”

Macquarie, Colonial and Vanguard all have a diversified structure in their fixed interest funds. Smith says: “We expect it [fixed interest] to outperform cash over an extended time ... even if we take out the returns of the early 90s.

“The bulk of a defensive amount is in fixed interest, typically 28 per cent to fixed and 2 percent cash in Vanguard Australia’s growth fund, so it’s an important allocation.” As such, Smith thinks simplicity should rule for all but the most sophisticated investors. “Even with the good names, the ranking varies … the shareholders are the last in line and the banks are the first, then the bondholders come in multiple tiers with senior debt, and then the hybrids, which may be third in line for a claim on the company assets, and so they may be priced differently at the issue price.”

He adds: “You hear about CDOs and the embedded option structures … so if one goes you’re OK, and if another goes it’s a domino, but if the third goes, then you’re done … if they’re a complex structure, then how can an individual come to grips with that? And do the advisers understand them? They [CDOs] appeal because of the returns, but certain events can bring it down, and the probability of those events is not zero.”

According to Smith: “We’re traditionalists, and like traditional bonds … as long as you keep the costs low. Sometimes complexity has appeal, but if they [the investment vehicles] are only issuing $100 million here and there, then you have to think about how they make a living. Effectively, they take high fees out of these structures for it to be a good business.”

Property funds

FIIG’s Jim Stening adds that SMSFs typically hold 5 per cent in fixed interest, and are especially vulnerable to underperformance if conditions change. On top of that, there is a tendency to favour the property sector, so if that sector turns down these vehicles will be doubly hit by the direct ownership and the exposure through debentures and hybrids.

However, the risk of a downturn in property is still a fair way off. Stening explains: “You’d have to have a more severe downturn like in the 1990s to have a problem. In Australia, corporate debt is relatively low and Australian companies are cashed up, so the underlying riskiness of the corporate sector is still relatively low.

“To have a problem, you would need a situation where the economy was pushed into recession.”