Stephen Hart examines fixed income assets and explores the arguments relating to direct investment or the use of managed funds.
Following my recent articles on the value of bonds and defining balanced funds, this month’s commentary sees a departure from the asset class selection discussion.
Here we take a practical look at the arguments for investing in fixed income assets using direct investment versus investment using managed funds.
As we will see, direct investment is an attractive option for investors seeking access to fixed income assets.
Unlike holding units in a managed fund where investors have no control over assets within the fund, direct investment means investors are the beneficial owner of a specific asset of their choice. Direct investing offers many benefits.
Firstly, direct investment in bonds provides the investor with the ability to mix different types of bonds to suit their own portfolio criteria.
Secondly, direct investors with a firm view on the future direction of interest rates can choose between fixed rate bonds or floating rate notes (FRN).
A fixed rate bond is a security that pays a fixed predetermined distribution or coupon during the life of the bond. A FRN is a security that pays a coupon linked to a variable benchmark.
In Australia, most FRNs are issued at a margin above the bank bill swap rate (BBSW).
Thirdly, direct investors enjoy planning advantages. Specific bonds can be selected because the cash flows suit the investor’s future needs. For example, an investor can match future commencement of an allocated pension with the cash flow from a maturing bond.
Fourthly, direct investors can choose when to sell their bonds as part of their overall tax planning.
However, while the above advantages are of importance, a meaningful comparison demands assessment against three prime criteria:
- fees;
- diversification; and
- liquidity.
Before we look at these criteria some comments on access for direct investors is called for.
While government bonds have been available in parcels from as little as $1,000, over the counter (OTC) corporate bonds have, until recently, been the exclusive territory of wholesale and sophisticated investors.
This is because access to OTC bonds via the settlement agency Austraclear limits settlement of single bond parcel sizes to a minimum of $500,000 (face value).
However, recent developments have seen one the opening up the over-the-counter market for ‘seasoned’ corporate bonds to investors looking to invest $50,000. Household name issuers of bonds including National Australia Bank, Macquarie Bank, Suncorp, Telstra and AXA are keenly sought. I will now examine the three criteria in more detail.
Fees
Generally, investors in fixed-income managed funds pay fees on entering and exiting the fund. They may also be required to pay annual management fees and in some cases a performance fee.
Generally, the higher the targeted return of the fund, the higher the fees.
There are no fees charged to a client for direct investments in bonds, and some brokers now provide custody services on a complimentary basis.
Managed funds and direct investors source their bond assets from banks and brokers.
The bid/offer spread charged by the bank/broker at the time of sale to the managed fund or direct investor is the market price for the asset being bought and sold and should not be confused with fees.
In a low return environment, management fees are important as fees of more than 50bps per year might represent roughly 10 per cent of an investor’s return if nominal bonds are earning roughly 5 per cent per year.
Accordingly, the case for direct investment strengthens as managed fund fee levels rise.
Diversification
The aim of diversification is to reduce risk by selecting non-correlated assets. Typically, diversification becomes more important as higher-risk assets, equities for example, are brought into the portfolio.
Diversification relies on the following assumptions:
- There is little or no correlation between assets; and
- The possibility that the security issuer will default on its liabilities or even move into bankruptcy.
In the Australian bond market assets are not correlated and there is a very low risk of default. As Figure 1 shows, the need for diversity increases as the credit risk of the bond increases.
Some fixed income securities incorporate more of an equity-like character, for example perpetual hybrids.
We can refer to the degree to which a bond has equity characteristics as the ‘equity delta’, so that a high equity delta means that the bond has a high relationship with the volatility of the equity market. The reverse is also true.
Many have argued that managed funds are best for a diversified fixed income portfolio.
The issue of diversification takes on more importance when the credit quality of the issuer is low and when the issuer is unregulated by institutions such as the Australian Prudential Regulation Authority.
In other words, because bonds rank above equities in the capital structure (see Figure 2) the need for diversification is reduced. Moreover, there is a risk that ongoing management fees will outweigh the benefits of diversification.
When assessing the Australian fixed rate bond benchmark using the UBS Composite Bonds Index, we can determine that:
- For the Government sub-component of the UBS composite bond index, some 61 per cent of the index, diversification is not relevant as the individual bond returns are highly correlated and the risk of default is extremely low;
- For the supra-national sub-component* of the UBS composite bond index, some 23 per cent of the index, diversification is not relevant as the risk is aligned with the Government sub-component above; and
- The credit sub-component of the UBS composite bond index represents some 16 per cent of the index by market value. All bonds in this sub-component are investment grade or better, so a small increase in diversification will be required because:
- As the credit quality of the bond weakens the total bond return becomes less correlated to other bond returns; and
- Diversity is a prudent measure notwithstanding the risk of default being low.
In summary, the arguments for diversification relate to a relatively small component of the Australian fixed income market: the credit sub-component.
More specifically, the diversification argument may be critical to only half of the total amount of the credit sub-component.
Adequate credit research can greatly assist investors when diversification is appropriate, always taking into account the need for some element of risk to drive return.
The arguments for diversification become more important where investors are acting without any guidance on credit and are making their selections from the riskier end of the credit spectrum.
Liquidity
The very high credit quality of Government and semi-government bonds, which constitute 61 per cent of the index, confirms the majority of Australian bonds are highly liquid.
In the case of the credit sub-component, the liquidity of individual securities varies but is found to be more than adequate in most cases.
Investors should be aware that as liquidity reduces, bond holders are typically rewarded with extra yield, in the form of an illiquidity premium. Inflation-linked bonds (issuers include semi-Governments, major banks and selected infrastructure groups) all reflect this premium.
Rewards for illiquidity are, therefore, available and direct investors can choose to target these higher yielding securities.
While liquidity is popularly regarded as being greater in a managed fund, the evidence suggests otherwise. The mixture of asset types in managed funds often impedes liquidity.
In a crisis situation, a fund manager may only be able to liquidate certain parts of the portfolio, risking fund seizure. Direct investment sidesteps these problems since liquidity remains with the individual securities.
Other issues
Several other issues require mention, such as the degree to which portfolios are transparent.
As indicated earlier, one of the prime benefits of direct investment is the ability of investors to build a portfolio aligned to individual preferences covering factors such as risk, liquidity, duration (weighted average life of the bond) and others as indicated in Figure 4.
Conclusion
In most cases, as Figure 4 demonstrates, the benefits favour direct investment over managed funds.
The managed fund structure does deliver diversification but, as I have shown above, diversification is really only merited when the investor is targeting a very small group from the full range of bonds available.
Direct investment in fixed income assets provides the investor with the ability to accurately time and match investments with future liabilities.
Investors enjoy the option of selecting a mix of fixed, floating, and inflation-linked bonds allowing them to tailor a portfolio to suit their immediate and longer term needs.
* The UBS Supranational and Sovereign Index includes supranational agencies, sovereigns including provincial or state Government obligations and sovereign guaranteed securities with an explicit Government guarantee or support from sovereign, provincial or state Governments.
Stephen Hart is director of planner services at FIIG Securities.
