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Rising inflation poses a huge challenge for investors and necessitates the need for higher yields to ensure portfolios and investment incomes are not declining.
Building a 6% Bond Portfolio
6%pa yield — that’s the magic number many investors said they need to achieve their desired lifestyle. What stood out to us was that many investors were heavily reliant on equities to do that heavy lifting. However, fixed income’s modest risk profile allows for an efficient return per unit of risk.
The team at Income Asset Management have taken on the challenge of putting together a hypothetical portfolio of fixed income assets that could deliver on income requirements with a 6%pa yield and offer some diversification.
We’ll explain why diversification is essential to make fixed income work in a portfolio and talk through the ten inclusions in our hypothetical portfolio.
Diversification is the Key
Whether it be in an equity portfolio, property, or fixed income, ensuring risk is spread across a range of individual investments within an asset class helps prevent large negative capital impacts from unforeseen events.
Fixed Income assets, including bonds, inflation-linked bonds, and floating rate notes, allow investors to diversify in four ways:
- Credit or issuer risk: The risk the borrower will default
- Interest rate exposure or duration risk: The term or length of the credit exposure
- Liquidity: How easy is it to get your capital back
- Currency: The currency in which the credit is issued
Fixed income investments also allow investors to manage cashflows (asset/liability match) through interest payments (coupons). Staggering maturity profiles of fixed income investments can help smooth out lumpier capital redemptions. There are few asset classes that can mitigate drawdown risk while providing income/return potential and liquidity.
To achieve a prudent level of diversification, it is important investors have access to a wide range of fixed income securities. Choice, or a diverse view of fixed income markets, is important to assess the value of securities against a broader backdrop of investment opportunities.
IAM Capital Markets are market agnostic. We asses fixed income securities trading in all currencies, through listed exchanges and investment grade and high yield markets globally. This approach ensures investors can adequately assess relative value, diversify portfolios, and access opportunities through different markets.
Drafting a diversified portfolio targeting a ‘high yield’ return of 6% per annum
Let’s get to our high-yield portfolio and run through the different bonds we have selected.
The portfolio includes ten equally-weighted investments spanning ASX-listed, AUD, and USD issues trading in over-the-counter (OTC) markets. The portfolio includes investment grade, sub investment grade, and issues that have not been rated by an agency.
IAM Capital Markets provide internal credit opinions from our Credit Strategy team and independent research reports from our research partner BondAdviser for all issues included in the portfolio.
When putting together the portfolio, these were the steps we followed:
- Range of credit ratings: we chose attackers (lower-rated) and defenders (higher-rated) to ensure that the portfolio can score and defend regularly.
- Range of industries: we chose a midfield that consists of various industries, from airports, banks, mining, telecommunications, and other financial services. Diversification of industries helps to eliminate idiosyncratic risk from a portfolio and lowers a portfolio’s variance. If a midfield is doing their job, the engine room is working.
- Range of maturities: we chose a mixture of short- and long-term bonds. Short-term bonds have less interest rate sensitivity and so act like goalkeepers for capital preservation. Long-term bonds have more interest rate sensitivity, and thus can be more volatile from a capital perspective. We call these the super substitutes!
- Currency: just like having a good manager and coach, you need multiple currencies, including AUD and USD respectively. Both react differently given their volatility relative to the market (or Beta). For instance, the AUD is more sensitive to the terms of trade (TOT) and commodity prices than the USD respectively. However, each currency is just as important to the overall team and desired portfolio outcome.
6% Sample Bond Portfolio
IAM Capital Markets provide internal credit opinions from our Credit Strategy team and independent research reports from our research partner BondAdviser for all issues included in the portfolio.
Latitude Group HLD (Unrated) A solid fintech provider that is better placed than other businesses to deal with implementation of stricter regulation given its long track record. The structure of Latitude notes is very strong. Distributions are deferrable (but cumulative), there is a dividend/buyback stopper, a change of control 5% step-up, and if Latitude notes are not called (at first call), the margin increases to 12.75-13%. Few domestic subordinated financials offer a coupon of BBSW3M+4.75%.
Capital Alliance AU Pty Ltd (Unrated) This is a high-yield senior secured property credit that has three operational hotels and two assets under construction. The covenant package includes a gearing LVR, asset LVR, minimum total tangible asset (TTA) clause, and an interest service reserve account (ISRA). A coupon of 10% for a substantial asset-lend looks appealing versus other high-yield names.
Jervois Mining USA (Unrated) This high-yield credit is uniquely placed in the battery metal thematic (nickel and cobalt). Recent underwritten equity raising has significantly de-risked the credit by raising additional liquidity that can be used over the construction period. First production is due in late 2022. A coupon of 12.5% looks appealing versus the broader USD high-yield universe and other metals and mining names.
Coburn Resources Pty Ltd: 10.735% (Unrated) A high-yield credit uniquely placed to the mineral sands thematic. Mineral sands can be used in a range of everyday household products. All major construction contracts have been awarded and 100% of offtakes have been secured. First production is due in late 2022. A coupon of 12% looks appealing versus the broader USD high-yield universe and other metals and mining names.
Other names in the portfolio which have an external rating (S&P/Fitch/Moody’s) include:
National Australia Bank (BBB-/NA/NA) A solid major bank Tier 1 (Hybrid) security offering a 4.95% coupon.
Sydney Airport Finance (BBB+/NA/Baa1) The number one airport across the country. Protects investors against rising inflation with a coupon of CPI + 3.12%.
Ampol (NA/NA/Baa3) A solid investment-grade credit with a structure which is supportive for investors. The company’s EBITDA looks like turning around quicker than first anticipated − driven by the global energy shortage. If not called in year 5.33, investors can convert to equity, which mitigates any non-call risk. The hybrid security offers a coupon of BBSW3M + 3.40%, which is very attractive compared to the investment-grade space.
Pacific National Finance (BBB-/BBB-/Baa3) A solid haulage company with an increasing revenue base from intermodal (non-coal related activities). This is the best investment-grade bond on a risk-return basis.
NBN Co Ltd (NA/AA/A1) An essential piece of infrastructure for the Australian economy that has strong bipartisan support from both major political parties.
Emeco Pty Ltd (B1/B+/B+) This solid high-yield mining services provider is benefiting from high commodity prices. Potential for upgrade from B+.
To find out more information on the sample portfolio, please call 1300 784 132 or visit Income Asset Management’s webpage here.
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Disclaimer
Sample portfolio disclosure
Pricing as at 14 February 2022.
IAM Capital Markets Limited (AFSL 283119) (‘IAM Capital Markets’) financial service business and provides general financial product advice only. As a result, this document, the Content and the Reports are not intended to provide financial product advice and must not be relied upon or construed as such. IAM Capital Markets does not express any opinion on the future or expected value of any financial product and does not explicitly or implicitly recommend or suggest an investment strategy of any kind. The Content and the Reports provided in this document have been prepared based on available data to which IAM Capital Markets have access. Neither the accuracy of that data nor the research methodology used to produce the Content and Reports can be or is guaranteed or warranted. Some of the research used to create the Content and the Reports is based on past performance. Past performance is not an indicator of future performance. The data generated by the research in the Content or the Reports is based on research methodology that has limitations; and some of the information in the Content or the Reports is based on information from third parties. IAM Capital Markets does not guarantee the currency of the Content or the Reports. If you would like to assess the currency, you should compare the Content or the Reports with more recent characteristics and performance of the assets mentioned within it.
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