Not All Bonds Are Created Equal Looking behind the yield of unlisted bonds.

Transcription

1 ? Not All Bonds Are Created Equal Looking behind the yield of unlisted bonds. Morningstar Credit Research 4 December 2014 John Likos, CFA Credit Analyst john.likos@morningstar.com Executive Summary We are becoming increasingly concerned that retail clients are buying unlisted bonds without looking behind the yield to understand the risks that come with these securities and whether those risks are appropriate for their investment profile. This report aims to assist investors to understand some of the key risks of purchasing unlisted bonds and provides essential questions to have at hand prior to making such investment decisions. Moreover, and most importantly, we list alternative options for exposure to the fixed income asset class which we believe are often more effective in providing attractive yield without undue risk relative to direct unlisted bond holdings. As interest rates remain low, investors continue to seek yield, often captivated by headline returns without regard for the accompanying risks of those investments. Recent strength in bond markets is creating a sense of overconfidence with respect to navigating bond risks, which have been subdued in a favourable global environment of low interest rates and high liquidity. Ravi Reddy Associate Analyst ravi.reddy@morningstar.com During the Morningstar Individual Investment Conference held in Sydney on 24 October 2014, several investors highlighted concerns they had about the unlisted bond market. Upon further discussion, it became apparent that many investors weren't aware of the risks that came with investing in these securities. Following this feedback, we thought it would be appropriate to review some of those key risks, particularly in a low interest rate environment where the search for yield remains strong. In this report, we identify some of these key risks, namely liquidity risk and credit risk, and suggest key questions investors need to ask before buying these bonds (refer to Appendix I). We also look at some alternative investment options to gain exposure to the fixed income asset class. Remember, in most cases, the higher the return, the higher the risk! Key Takeaways Exploiting potential value opportunities in unlisted bonds should generally be left to sophisticated, experienced fixed income investors with a high risk tolerance. Understand the bonds you hold, how they are correlated with one another and how they would react in a market downturn. Remember the role of bonds in a portfolio: (i) capital preservation; (ii) provide a stable income; and (iii) diversify your investment portfolio. Unlisted bond exposures may compromise these critical functions. Demand full disclosure of fees and charges when transacting in direct bonds. The bond market commission and fee structure is significantly more opaque when compared with the equity market. Most retail investors are better served accessing the fixed income asset class via managed funds, exchange traded funds or listed alternatives. contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: , AFSL: ) and/or Morningstar Research Ltd, subsidiaries of

2 Page 2 of 10 The Australian Bond Market a Brief Overview The Australian bond market is made up of various types of securities, including those issued by the Commonwealth Government, state and territory governments, covered bonds, non-financial corporate bonds, financials bonds, bonds issued by foreign borrowers (referred to as kangaroo bonds) and various types of asset-backed securities. We are excluding hybrid securities from this analysis as we don't consider them part of the traditional fixed income asset class. Hybrid securities are a unique asset class having debt- and equity-like characteristics, whereas fixed income comprises pure debt securities. Australia's bond market has continued to develop in line with the needs of regulators, investors and issuers. Exhibit 1 highlights the evolution of the Australian bond market during the past 20 years. Exhibit 1. Bonds on Issue in Australia These charts provide some interesting insights into the Australian bond market. In particular: The Australian bond market continues to grow and attract both domestic and foreign issuers. The Australian bond market represented approximately 98% of gross domestic product, or GDP, as at December 2013 compared with 84% of GDP at June Public-sector issuance has been the dominant contributor to bond growth since 2007, driven by state and federal governments funding their budget deficits. Issues by financial services companies have fallen from their recent peak as a consequence of banks utilising their growing deposit funding base and slower lending growth.

3 Page 3 of 10 Asset-backed security, or ABS, issuance, which is largely made up of residential mortgage-backed securities, or RMBS, decreased sharply between 2007 and 2013, but has shown signs of recovery during Kangaroo bond issuance has increased significantly as overseas issuers look to diversify their funding into the Australian market. The global financial crisis has significantly shaped the size and composition of domestic bond markets as can be seen from the sharp decrease in ABS issuance and the sharp rise in issuance from the financials sector during this period. Unfortunately for retail investors, the overwhelming majority of bonds are issued to wholesale clients, where subsequent trading is undertaken over the counter, or OTC, as opposed to being listed on the Australian Securities Exchange, or ASX. Listed direct bond investment options are limited for investors, mainly made up of Australian government bonds that can be bought or sold the same way shares are traded. Liquidity Risk Liquidity risk, in this context, refers to the ability to buy or sell a bond on a timely basis at a fair price. Low levels of liquidity make it difficult to buy or sell a bond, raising the risk of having to buy at an inflated price or sell at a capital loss. Although investors may purchase bonds with the intention of holding to maturity, the scenario may still arise where these positions need to be sold, therefore investors should always be aware of the illiquidity of their investments. There are numerous indicators of liquidity in the bond market, including the bid-ask spread, issue size, number of market makers and whether the issuer is a public company or not. We have a preference for bonds that display a narrow average bid-ask spread, are part of a larger issue size, are issued by publicly listed companies with continuous disclosure requirements and are traded in a market that has a market maker. We acknowledge it may be difficult to obtain all these features, but the more of these features the bond possesses, the better. Bid-Ask Spread This refers to the amount by which the ask price exceeds the bid price, or the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to sell at. The bid-ask spread is a primary indicator of a bond's liquidity. The wider the spread, the less liquid the bond. The bidask spread is likely to increase in times of market distress. The bid-ask spread is a transaction cost to the investor which has the effect of decreasing the total return on the investment. The wider the bid-ask spread, the greater risk the investor runs of having to forego some return to get the transaction done, impacting the total return of the investment.

4 Page 4 of 10 Bid-ask spread example. A broker-dealer quotes a bid-ask price for a bond of $99.50-$100.00, implying a bid-ask spread of 50 cents. The spread as a percentage is 0.50% (50 cents divided by the buy price of $100.00). An investor who buys $100 worth of this bond and immediately sells it back to the broker-dealer incurs a loss of 50 cents, reflecting the spread of 0.50%. If the original bid-ask price was $99.00-$100.00, the spread as a percentage is 1.00%, increasing the loss on the same transaction to double at $1.00. Issue Size The issue size of a bond will impact its liquidity and attractiveness to other buyers. Smaller issues will generally have a smaller investor base, resulting in lower trading liquidity. Compare the issue size of the bond to other bonds on offer. Number of Market Makers Think about who will most likely take the opposite end of the trade if you wanted to buy or sell and how far prices need to adjust before someone is willing to take the other side of the trade. A market maker is a dealer that provides liquidity by undertaking to buy or sell securities at specified prices at all times. The ASX has appointed three market makers to provide continuous bid and offer prices for all Australian government bonds. These market makers are obliged to quote a minimum volume and maximum bidask spread, so that investors have confidence there will be sufficient liquidity in the market and that the quoted prices are competitive. Public or Private Company Due to the lower levels of public disclosure required by private companies, their bonds tend to be less liquid than those of a public company. Outside of professional fixed income investors that can analyse all the relevant risks, we advise most investors to stick to publicly listed issuers because of their continuous disclosure requirements. On 14 October 2014, the assistant governor of the Reserve Bank of Australia, Guy Debelle, raised some excellent points in a speech discussing issues around pricing in financial markets. We encourage readers to read what Mr. Debelle had to say, particularly regarding market liquidity, via the link provided. ( Case Study 1: Tatts Bonds (ASX Code: TTSHA) 12-month average bid-ask spread: 117 basis points. Issue size: AUD 200 million. Market Makers: None. Public or Private: Public. Comments: Although it is listed on the ASX, it currently displays a very wide bid-ask spread of 117 basis points, or 1.17%. The issue size of AUD 200 million is small by institutional standards, but medium when compared against other retail bonds. There are no market makers in these bonds, though the issuer, Tatts Group, is listed on the ASX and complies with continuous disclosure requirements. We would consider these bonds to have high liquidity risk.

5 Page 5 of 10 Case Study 2: 4.5% Treasury Bonds due 15 April 2020 (ASX Code: GSBG20) 12-month average bid-ask spread: 16 basis points. Issue size: N/A, Exchange Traded Treasury Bond. Market Makers: Yes. Public or Private: N/A. Comments: A low bid-ask spread, an exchange-traded bond, market makers and high levels of public disclosure. All indicators point to a low level of liquidity risk. Investors that envisage the possibility of needing to sell their bonds should always monitor the liquidity profile of their investments. For investors that plan to hold a bond to maturity, liquidity risk may not appear to be a concern; however, we believe that liquidity should always be a consideration for clients as an unexpected need to access the principal may arise. Credit Risk Credit risk refers to the risk that the borrower, or bond issuer, defaults on a payment, such as a coupon or principal payment. An investor is essentially lending money to an issuer, so investors need to assess the issuer's ability to make timely distribution payments and return the principal on maturity. Credit risk is best assessed via credit analysis of the issuer and the bond in question. Unfortunately for many investors, this is beyond their expertise, so an alternative is needed. We recommend utilising Morningstar's independent equity research as a starting point to understanding the profile of the issuer. Unlisted bonds present a dilemma to retail investors in that it becomes difficult not only to assess how risky they are, but to derive a relative valuation by comparing them to other bonds. For this reason, it becomes critical to undertake research on the investment and cross reference the findings with Morningstar's research. We recommend retail investors read Morningstar's latest research on the issuer, taking particular note of the stewardship rating, uncertainty rating and whether or not it has an economic moat. Morningstar's through-the-cycle methodology is particularly useful to gain an insight into the long-term prospects of an issuer. High-risk investors that have appetite for the unlisted bond asset class should still implement a thorough due diligence process to help understand the risks of the investment and whether the return being offered in the form of the coupon is commensurate with those risks. It is important to read the prospectus as well as the issuer's publicly disclosed financial and business-related information, such as annual reports, management reports, earnings call transcripts and investor presentations. It is also important to understand the characteristics of the bond and how the bond compares with bonds of similar quality, structure and maturity. If uncertain, ask your financial advisor for further clarification or consider the easier-to-assess investment options discussed below. Appendices II and III provide a useful template for investors to use as a starting point to understand the credit risk profile of their investment. We have split this template into two sections, Business Risk and Financial Risk. For the purposes of this report, business risk analysis includes an examination of a company's industry risk, market positioning and management efficiency. Financial risk analysis examines the financial profile of the issuer by reviewing the balance sheet, the profit and loss statement, the cash

6 Page 6 of 10 flow statement and the liquidity position. Combining the two should provide a basic overview of the issuer. This template should not form the basis of an investment decision, but is best read in conjunction with Morningstar's industry or issuer-specific research. Prior to investing in unlisted bonds, it is important to seek out independent advice as to whether the investment is suitable for your investment profile. ETFs and Managed Funds as Alternative Fixed-Income Options Alternative options for retail clients to get exposure to fixed income include exchange traded funds, or ETFs, and managed funds. Morningstar provides independent research on several fixed-income focused managed funds and ETFs. An ETF comprises a portfolio of securities that typically has a passive strategy which tracks an index. Compared with a managed fund, ETFs tend to have lower fees, lower turnover of underlying securities and are listed on the ASX with market makers providing liquidity. However, due to their infancy, as well as a preference of many for active management, retail clients might find managed funds more suitable. Managed funds also hold a basket of securities, but offer a greater choice of investment options when compared with ETFs. Managed funds can be diversified across many characteristics, including, but not limited to, types of fixed-income securities, geography, issuers, average credit rating and strategy. Compared with a consolidated investment in a single-issuer fixed income security, ETFs and managed funds provide significantly more diversification. Although the retail investors are subject to a management fee, they have the confidence of knowing that experienced professionals are undertaking an extensive due diligence process on their behalf to make the best investment decisions. Exhibit 2 shows the performance and some of the characteristics of the PIMCO Australian Bond fund, which has a Gold rating from Morningstar. Exhibit 2. PIMCO Australian Bond Fund Performance and Characteristics Source: Morningstar Annualised Return 1 Year 3 Year 5 Year 10 Year Credit Ratings Income Return 5.34% 5.79% 7.63% 6.93% AAA 50.1% Growth Return 1.59% 0.78% 0.11% -0.09% AA 20.0% Total Return 6.93% 6.57% 7.74% 6.84% A 17.5% BBB 12.0% Maximum management fee pa: 0.50% (on a $10,000 investment this equals $50 annually) BB 0.1% Distribution frequency: quarterly Below BB 0.4% Average weighted coupon: 5.33% Average Credit Rating A Risk category: moderate

7 Page 7 of 10 Appendix I Questions to Ask Your Broker/Adviser When Buying a Bond Understanding the liquidity risk of your bond investment 1. What is the current, or 12-month average, value and volatility of the bid-ask spread on the bond and how does that compare with other bonds being offered? 2. What is the issue size of the bond and how does it compare with other bonds? 3. Is there a market maker in the bond? 4. Look at a history of transactions and transaction amounts in that bond. Does it seem low, normal or high relative to the size of the issue? 5. Is the bond issued by a publicly listed or private issuer? Understanding the credit risk of your bond investment 1. What terms and conditions does the bond have? What protections and rights does the bond provide in stressed scenarios? Are there any unfavourable terms? 2. Are any covenants in the terms of the bond? What are they and how comfortable is the issuer's current status relative to those covenants? How often are they reported? 3. Is the bond secured against any assets? What are the assets and the recovery prospects on these assets in a worst-case scenario? 4. Where does the bond stand on the capital structure? 5. Who are the major investors/holders in these bonds? Are there any institutional investors? 6. What is Morningstar's view of the issuer? What is the Morningstar stewardship/uncertainty/moat rating? Does Morningstar cover it at all? If not, why not? Other questions to ask 1. What is the broker's commission fee structure? How is the broker making money and who is paying for it? Is there a commission paid on the bond transaction? Is there an additional mark-up or mark-down of the bond price? How are these fees and charges calculated? 2. Is the yield to maturity figure being quoted pre- or post-commission fees? If pre-commission fees, what is the post-fee yield to maturity? 3. Is the pricing being provided by an independent dealer? Does the dealer have a relationship with the issuer? Has the dealer collected fees from the issuer? It's important that all relationships are disclosed prior to transacting. 4. What is the maturity of the bond? Does this match your intended exposure timeline? 5. Does the bond include any early redemption features at the discretion of the issuer? This may decrease your return if the bond is called early as well as increase reinvestment risk as alternative investments must be found at the time of the call. 6. Is the bond a fixed-rate or floating-rate bond? How would it behave in different interest rate environments? 7. Are you being asked to transact regularly? Bond portfolios should not exhibit high turnover. 8. What is the yield to maturity of the bond? If intending to hold the bond to maturity, this is the yield you should be looking at, not the running yield. If you are intending to sell the bond before maturity, you must be comfortable with the liquidity profile of the bond. 9. Relative-value analysis is a critical part of credit analysis. This is where the bond is priced against comparable bonds to determine if it's cheap or expensive. Have you been provided with a relative valuation? Are these comparable bonds? If not, you may be buying an expensive bond.

8 Page 8 of 10 Appendix II Business Risk Profile Specific Risk Issues to Consider Risk Level Checklist 1. Sensitivity of earnings to changes in the business cycle 2. Intensity of competition 3. Supplier and buyer power 4. Barriers to entry Industry Risk 5. Industry-specific risks For example: environmental, terrorism, litigation, political and regulatory risks 6. Threat of substitute products 7. Structural risks of the industry 8. Changes in consumer preferences 9. Long-term outlook for industry profitability 1. Quality and diversity of products being sold 2. Brand strength and customer loyalty 3. Current market share, historical trends, outlook 4. Sales mix by (i) customer; (ii) geography; (iii) segment Market Position 5. Sustainability of earnings and potential revenue opportunities 6. Flexibility of the cost base. Is it easy to cut costs? Mix of fixed versus variable costs 7. Price and/or product differentiation 8. Long-term earnings outlook 9. Size of the company 1. Corporate governance record For example, accessibility, honesty, transparency, strategic clarity 2. Ability to identify and execute new earnings opportunities Management 3. Track record in acquistions and cost management 4. Key personnel stability 5. Financial transparency

9 Page 9 of 10 Appendix III Financial Risk Profile Specific Risk Issues to Consider Risk Level Checklist 1. Leverage ratios, including when adjusted for off-balance-sheet obligations. For example, total debt to EBITDA, net debt to EBITDA, debt to capital, operating cash flow to debt. Balance Sheet 2. Are there any off-balance-sheet obligations? Are they in the adjusted debt numbers? For example, operating leases, post-retirement obligations, guarantees, contingent obligations. These can be found in notes to accounts but not on the balance sheet. 3. Asset values on the balance sheet compared to real market values of these assets, tangible versus intangible assets and so forth. For example, is goodwill overstated and at risk of being impaired? 4. What is the issuer's debt maturity schedule? An ideal scenario is a well spread-out debt maturity schedule. Are there any large repayments due soon? 5. Priority of debt in the capital structure. Where does your holding sit? Order of priority before you. 1. Profitability ratios. For example, gross profit margins, operating profit margins, return on equity. 2. Revenue, operating income and net income: growth and trends. Profit & Loss 3. Long-term outlook for earnings. 4. Flexibitlity of operating costs and ability to generate profits and manage assets. 1. Cash flow ratios. Operating cash flow divided by debt, funds from operations divided by total debt, interest coverage ratios, operating cash flow divided by capital expenditure. 2. Stability of operating and free cash flow generation. 3. Ability to decrease/increase capital expenditure and dividends within current cash flow generation. Cash Flow 4. Capital expenditure numbers separated into maintenance and discretionary. 5. Source of cash flow. Are they driven by internal or external sources, such as asset sales and debt issuance. The preference is for strong internal cash flow generation. 6. Company dividend strategy and its impact on debt capacity. 1. Liquidity profile. For example: (available cash balance + undrawn committed credit facilities short-term debt). Is the cash balance accessible immediately if required? 2. Liquidity buffer in place to absorb negative surprise events. Liquidity 3. Ability to access funds in the capital market. What are the most likely options in the event of further funding requirements? 4. Quality and saleability of assets. 5. Capacity to fund potential merger and acquisition opportunities without further capital raising.

10 Page 10 of 10 Appendix IV Glossary of Terms BBSW The bank bill swap, or BBSW, rate is the average mid-rate for Australian dollar bills of exchange accepted by an approved bank, having a tenor with a designated maturity that appears on an approved information vendor's service. Duration The change in the value of a fixed-income security that will result from a 1% change in interest rates. Duration is stated in years. For example, a five-year duration means the bond will decrease in value by 5% if interest rates rise 1% and will increase in value by 5% if interest rates fall 1%. Duration is a weighted measure of the length of time the bond will pay out. Face Value The face value of the security is the issue price, typically being AUD 100 per security. Mark-Up/Down The mark-up is the difference between the price the dealer paid for the security and the price at which it sells it. The mark-down is subtracted from the selling price when you sell a security to a broker-dealer. Running Yield Annual coupon payments expressed as a percentage of the market value of the security. Time to Maturity The time expressed in number of years to a reset date and/or maturity date, where on such date, either the terms of the security may change or the security may be redeemed. Volatility The degree to which the price of a security tends to fluctuate. Yield to Maturity, or YTM The internal rate of return to maturity or other pseudo-maturity event.