Last week we ran two portfolios: a flight to quality or ‘safe harbour’ portfolio and a diversified unrated portfolio. This week we combine the two and demonstrate how they work in tandem, producing a diversified portfolio with 26 names whilst maintaining an attractive yield to maturity of 5.5%
Last week we ran two portfolios: a flight to quality or ‘safe harbour’ portfolio and a diversified unrated portfolio. (To view these articles please see the links below).
Having assessed the probability of default and the different characteristics of investment grade and sub-investment grade/unrated, we derived three simple rules for constructing a portfolio:
1. The majority of your portfolio should be investment grade.
2. The allocation to high yield bonds needs to more diversified than your investment grade portfolio to ensure you are not overly exposed to the default of any single bond.
3. As risk increases you must ensure you are appropriately compensated via higher return.
This week we combine the two portfolios and assess the characteristics of the combined portfolio using these three rules.
Detailed below is the combined portfolio and some of the key exposure statistics:
Using the three rules above we note the following:
1. The majority of your portfolio should be investment grade.
• The combined portfolio is for a circa $550,000 spend, with 68% allocated to investment grade and 32% comprised of unrated bonds, or roughly a two-third investment grade and one-third sub-investment grade/unrated mix
• The allocations can obviously be changed to suit investor preferences
• The portfolio has a high allocation to AA rated (25%) and single-A rated (19%) bonds, as demonstrated by the left hand pie chart above
• We again highlight the attractiveness of the inflation linked bonds (ILBs) as high quality or ‘safe harbour’ investments. These capital indexed bonds (CIBs) and indexed annuity bonds (IABs) are both highly rated but are also removed from the volatility of offshore markets (e.g. China and Europe/Greece). Many of these ILB entities supply essential infrastructure and are backed by regulated, monopoly and/or government income streams. Further, they provide ‘duration’ or interest rate risk that is important in an overall portfolio setting (i.e. a countercyclical buffer against equities) with the added bonus of inflation protection and expected returns in-excess of 5%
2. The allocation to high yield bonds needs to more diversified than your investment grade portfolio to ensure you are not overly exposed to the default of any single bond.
• Highly diversified portfolio with 26 individual companies from various sectors
• No single company or issuer exposure over 10% and the larger exposures are all to investment grade names
• No high yield/unrated exposure over 2% (each allocated $10,000 face value), meaning that the portfolio is not overly exposed to any one of these higher risk entities that are added to enhance overall returns
• Diversified by bond type (with the ability to change to suit investor preferences):
o 45% allocation to fixed
o 20% to floating
o 19% to CIBs
o 16% to IABs
• The portfolio provides a good balance as well as significant inflation protection, while still achieving a high yield to maturity
3. As risk increases you must ensure you are appropriately compensated via higher return.
• An impressive indicative yield to maturity of 5.5% given the diversified nature and fact that the cash rate is just 2% and five and ten year swap rates are around 2.7% and 3.3% respectively
• The high yield/unrated component has a yield to maturity of approximately 6.7%, average trading margin of over 400bps and a running yield of almost 7.3%, which is viewed as appealing given where base rates are
• A high average trading margin across the entire portfolio of 255bps
Notes on the portfolio:
Where there is an issuer with a fixed and a floating option, the floating has been chosen (i.e. G8, McPherson’s and SCT). Investors not concerned by the prospect of rising rates could increase returns by replacing these with the fixed lines. Further diversification is also possible by including any of the three fixed Qantas sub-investment grade bonds.
As mentioned last week, a number of tweaks could be included to match individual preferences, including:
• An increased allocation to government bonds, the true ‘flight to quality’ asset, although this would likely see the yield to maturity fall
• Inclusion of residential mortgage backed securities (RMBS) as alternatives to floating rate notes. AA- rated RMBS with a weighted average life of eight years are available with trading margins of circa +220bps and BBB rated options with a five years weighted average life trade around +300bps
• Those worried by the prospect of rising rates could increase floating rate options, although much of the countercyclical buffer/smoothing effect detailed in the analysis above is provided by the increased price in fixed rate bonds in times of stress
All prices and yields are a guide only and subject to market availability. The yields and margins quoted assume all bonds in the portfolio run to maturity, however it is possible that some may be called before the maturity date which would impact the figures slightly. FIIG does not make a market in these securities.