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Fixed Interest: Risk vs. Return

We have recently topped up fixed interest for the first time in a long time.

I have just written our next investment newsletter where I explain a little about fixed interest and why we have made this move:

Fixed interest encompasses both government bonds and corporate bonds. Through buying a bond you are lending money to either a government or a company for a fixed level of interest, for a fixed period of time. However, the bond does not have to be held until maturity and can be traded at any time. The market value of the bond will depend on various factors such as the potential return until maturity and the possible return you could obtain elsewhere.

For example, if you bought a 10 year UK government bond (or gilt) right now, lending money to the government for the next 10 years, you would receive a rate of return of 1.37% pa. If you hold until maturity, your capital is safe as it is guaranteed by the government.

Currently, interest rates are 0.5% so this is 0.87% pa more than rates. If the Bank of England put up base rate, say to 1.5% pa, then the bond would be yielding less than cash. The price would probably fall to adjust to the new rate environment and to maintain a similar premium over rates. However, if rates went down then the price would probably go up.

Another factor that drives investors to buy government bonds is fear. When investors are worried and don’t want to buy equities they can focus more on protecting their capital than on returns. Whilst 1.37% pa is a pretty poor return and would probably be less than inflation over ten years, the government guarantee can be attractive. As a result, the price of gilts has been driven up to very expensive levels by current investor nerves.

Corporate bonds work in the same way as gilts but with an additional layer of complexity. Buying a corporate bond means lending to a company. Companies can go bust and so corporate bonds tend to have higher yields than gilts to compensate for the risk of default.

In normal conditions, corporate bonds and gilts tend to move in similar directions but in times of fear they can move opposite ways. As fears of recession rise, then fears of corporate bond defaults increase.

We believe these fears are overdone and whilst economic growth is undoubtedly “soft”, there seems little likelihood of a global recession. This led to a mismatch of value in our view where corporate bonds yields had a historically wide premium over gilts. As a result, we felt it was time to top up fixed interest as the potential return was attractive.

In this blog, I’ll give a bit more detail about why we feel fixed interest is attractive and some of the analysis we carry out to ensure we don’t take too much risk.

The Potential Return

The chart below shows how both corporate bond and gilt yields have changed over the past two years. The orange line shows the yield on corporate bonds (Iboxx Sterling Corporate Bond Index) and the blue line shows the yield on the ten year gilt. The light blue shaded area shows the “spread” or difference between the two:

EQ_graph_1.png

As you can see, in the early part of 2016 the spread between the two lines increased quite sharply. This is because the yields on corporate bonds rose (as their prices declined) and the yields on gilts went down as their prices rose.

The yield on the corporate bond index rose from 3% in February 2015 to 4.1% in February 2016, and the premium over gilts went up from around 1.5% to over 2.6% during the same time.

A 4% annual return on corporate bonds seemed to be pretty attractive with interest rates still at 0.5% and seemingly going nowhere fast. In our fixed interest portfolio we saw even more opportunity, with our portfolio having an income yield of almost 5% and a yield to maturity of around 5.8% pa. The yield to maturity would be the annual return if all bonds were held until they matured and none of them defaulted (before charges).

Risk Analysis

The reason our funds have a higher potential return is that they do take credit risk, and so it is important for us to quantify this risk.

Bonds are generally given a risk score by credit rating agencies. These range from AAA for the safest borrowers such as the US or German governments, to CCC for the most insecure companies. In theory, there is very little risk of default on an AAA rated bond and quite a high risk of default on a CCC rated bond.

Some bonds aren’t given ratings. If a company wants Moody’s or Standard & Poors to give it a rating, then they have to pay the agency for the privilege. Some firms don’t want to do this and so their bonds don’t carry a rating.

One of the funds we hold specialises in carrying out their own research into these unrated bonds. They feel many of these bonds are ignored purely because they haven’t got a rating and they are perceived as riskier than they are. They tend to have higher yields because of it.

Our fixed interest portfolio carries a wide range of bonds from AAA to non-rated. However, credit risk is not the only factor we need to look at. Risk also depends on the term to maturity of the bonds. A 50 year bond clearly is more risky than a one year bond, since there is much more opportunity for a company to run into trouble.

Our portfolio carries a wide spread of maturity dates. The average maturity is around five years but some bonds will mature very shortly and some not for more than 20 years.

We carry out very detailed analysis on all our portfolios as we are sent the full holdings of all the funds we invest in on a monthly basis. This is not publically available information and is jealously guarded by the fund managers, meaning we have had to sign non-disclosure agreements in order to keep this private. Getting the full holdings allows us to carry out very in-depth analysis both on the opportunities and the risks.

What we don’t want to see when we analyse the portfolios is lowly rated bonds with long maturity dates. We are happy for very secure AAA bonds to have long terms if that is where the manager feels is the best place to invest but we would want the riskier bonds to have shorter maturities.

The table below shows some of the concentration analysis we carry out. It categorises all bonds by credit rating; with the highest rating on the left and lowest on the right, plus the time until maturity (shortest in the top row and longest at the bottom). The areas where we have the highest concentration are in red, with the lowest concentration in blue. White means we hold no bonds in that category.

What you can see from the below is that the highest concentrations are in long dated AAA bonds, and in short dated (less than one year) non-rated bonds:

EQ_graph_2.png

This is exactly what we want to see. In theory the riskiest bonds in terms of credit score are more likely to mature in the next 12 months. In total, 13.75% of the portfolio will mature in the next year.

Not Fixed…

Of course credit ratings are only a matter of opinion. They can also change.

Another piece of analysis we carry out is looking at how much of our portfolio is on “positive watch” where the credit rating is likely to increase, or “negative watch” where there’s a likelihood of it decreasing.

At present, 13% of the bonds in the portfolio are on positive watch and only 4.7% on negative watch.

In particular, what we look at most carefully are how many BBB rated bonds are potentially about to be downgraded.

Bonds with a rating of BBB or above are classed as “investment grade” or high quality bonds. A large number of fixed interest funds only invest in investment grade bonds.

Anything below BBB is classed as “high yield”. This can be an interesting area but a large number of funds are simply not allowed to hold high yield bonds. This means that if a BBB rated bond is downgraded then a lot of funds will sell it, meaning the price will probably drop.

Only 1.5% of our portfolio is in BBB rated bonds which are on negative watch.

As you can see, there’s a lot of work which goes into analysing the portfolios, not just in terms of the returns we think can be achieved but also ensuring we are comfortable with the level of risk being taken.

 

The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.