Fixed IncomeMar 3 2014

Finding the right risk/reward balance

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Looking outside the traditional fixed income space could offer benefits for investors. Whether this is the protection of short duration, floating rate notes or a bond that has the benefit of being correlated with equity.

Asset-backed securities do not conjure positive thoughts in every investor’s mind, as they are linked with the financial crisis, but the asset class cannot be generalised. These securities’ income payments, and so their value, are derived from and backed by a specified pool of underlying assets.

The TwentyFour Monument Bond fund is made up of residential mortgage backed securities (RMBS) and is investment-grade only, with 90 per cent of the fund AAA or AA-rated. TwentyFour Asset Management head of distribution John Magrath says the fund is the firm’s alternative to a gilt or investment-grade corporate bond fund, but without the same duration risk, as it is all floating rate.

He adds: “Asset-backed securities will benefit from a rate rise environment, especially RMBS, because you get a tick-for-tick uptick in the yield inline with base rates. This removes interest rate risk. The refinancing market has picked up with more people refinancing, which means we get paid back from the mortgage bonds early, which means our returns go up.”

Brewin Dolphin fund analyst Victoria Hasler says that the firm holds both secured loans and asset-backed securities, which have similar properties. “Income is in high demand and so most things that pay a decent income are fairly fully valued.”

Ms Hasler says the loans are floating rate and have no duration, but look fairly valued now and investors don’t necessarily want to be buying at these levels. She adds: “There is more value in asset backed securities, as they have not rallied as hard as the loans have.”

Another alternative way to access fixed income is through convertible bonds, which are bonds that can be converted into equities at a later date.

Justin Craib-Cox, who runs the Aviva Investors Global Convertibles fund, says that convertibles offer the downside protection of a bond, but equity sensitivity. He explains: “If the underlying equity were to rise or fall by an equal amount, the convertible bond price would increase with the rising price of equity, but would fall by less due to the presence of the bond floor.”

He notes that convertibles are shorter duration than other bonds, at roughly five years, so they are not hit as hard when rates rise. Mr Craib-Cox adds: “The embedded equity element helps improve returns and this works well when there is higher inflation resulting from a better economic growth environment.”

The final benefit is that convertibles offer diversification, as this equity element of the bond means it is uncorrelated to other fixed income.

Anthony Gillham, who runs the Old Mutual Voyager Strategic Bond fund, says another form of convertible is additional tier one capital (ATier1), which are Basel III compliant bonds, issued by banks and designed to be loss-absorbing. He suggests these convertibles are priced attractively, where investors are compensated for the risk of the bond.

“You look at European banks’ capital levels and compare that to the levels they need to fall to in order to trigger these bonds converting to equity. There is a very big gap. Yet some of these bonds are priced as if that gap was smaller.”

Mr Gillham says ATier1 capital trades more like bonds while convertibles trade differently as they have equity sensitivity. He says: “I own European convertibles instead of European high yield. I think the risk/reward balance is more attractive. In European high yield, the best that’s going to happen is I’m going to earn a yield on the index. The worst that is going to happen is I am going to suffer large price declines. The alternative is buying into convertibles, an asset class that does not have a capped upside and where the risk and reward is more balanced.”

Hargreaves Lansdown senior investment manager Adrian Lowcock says it pays to keep it simple when investing in fixed income. “With convertibles, investors have to deal with understanding the conversion terms of the bond and how this affects the bond’s performance.

“Convertible bonds can behave more like equities if they are in the money – i.e worth converting.”

Joanne Ellul is a freelance journalist

EXPERT VIEW

Stephanie Carbonneil, senior investment manager, Architas, says:

“As the new Basel III regulation comes into force, European banks are being required to deleverage and improve their capital adequacy, and this includes increasing the amount and style of Tier 1 capital. As CoCos will fall into this new Tier 1 classification, we would expect issuance to increase significantly this year.

“CoCos offer attractive yields compared with the rest of fixed income and their default rates remain relatively low. However, it is also important to be aware of the risk inherent to these instruments: if the company encounters a ‘sudden death’, there is the chance that the bond could be written off entirely.

“As CoCos are not part of US Tier 1, Europe is likely to see the greatest increase in issuance. Within this we believe regions such as the UK and Switzerland offer a good access point.”

GLOSSARY

FIXED INCOME ALTERNATIVES

Additional Tier 1 Capital (ATier1)

Under the Basel III, rules institutions need to increase their capital adequacy including levels of Tier 1 capital. The majority of this will be common equity Tier 1 capital, but the rules now allow for Additional capital, including ‘hybrid’ capital instruments that can absorb losses by being written down or converted into common equity Tier 1 capital.

Collaterised Debt Obligation (CDO)

A security backed by a pool of bonds, loans and other assets. CDOs are similar in structure to a collateralised mortgage obligation (CMO) but do not specialise in one type of debt.

Credit Default Swap (CDS)

A swap in which one party provides a guarantee for the benefit of a second counterparty relating to the credit performance of an issuer on its debt obligations. The counterparty hedging against the risk of the issuer’s default (the buyer of the CDS) makes periodic payments to the other counterparty (the CDS seller) for laying off this risk, while the CDS seller only makes a payment in the event of a default.

Convertible Bond

Bonds that contain a provision allowing the holder to exchange the bond for a specified number of shares of a different security (usually common stock) issued by the same company that issued the bond; terms of conversion are disclosed at the time the bond is issued.

Contingent Convertibles (CoCos)

These instruments are slightly different to traditional convertible bonds, as the conversion is usually dependent on a specific event happening, such as an issuer coming under extreme stress and the core capital ratio falls below a certain level.

Floating Rate Note

A security with a coupon rate or interest rate that varies based on either a direct or inverse relationship to one or more designated short-term rate index.

Mortgage backed securities (MBS)

Securities whose cashflows are derived from underlying mortgage loans.

Zero Coupon Bond (Zeros)

Fixed income securities which do not pay a coupon and are instead issued at a discount.

Source: Freddie Mac; Fidelity; Accenture; AMP Capital; Nasdaq