Investors fearful of major equity market declines often decide to include in their portfolios relatively “safe” assets such as cash and bonds so as to limit their downside. The problem with this approach is that seeking safety can be costly in terms of forgone returns, especially given today’s generally low level of interest rates. Investing in long-dated, investment grade corporate bonds offers a potentially attractive way for investors to obtain both decent regular income returns while also seeking to limit losses in major “risk-off” periods.
Fixed-Rates Bonds – diversification, but at a cost
Fixed-rate bonds can often provide a handy source of diversification within portfolios with heavy exposure to equities. As evident in the chart below, this reflects the fact that both interest rates and equity market performance tends to follow the economic cycle. When economic conditions are weak, equities returns tend to decline due to reduced prospects for corporate earnings. But these are also periods when interest rates tend to fall due to reduced demand for credit and expectations that the Reserve Bank will cut its official policy interest rate. Lower market interest rates, in turn, tend to boost the value of fixed-rate bonds, because the future stream of fixed nominal interest payments they offer are worth more in today’s dollars.
By contrast, as economic conditions improve, equity markets and interest rates tend to rise, with the latter then denting the return from fixed-rate bonds. All up, this suggests that the returns of fixed-rate, investment grade bonds and equities tend to be negatively correlated – when one asset class is doing well, the other is not, and vice-versa. The greater the term of maturity, or duration, of such fixed-rate bonds, the greater their price sensitivity to interest rates, and hence the degree to which their returns tend to be negatively correlated with equities.
Past performance is not an indicator of future performance.
That said, the problem with investing in fixed-rate bonds – especially government bonds – is that the yields on offer are relatively low. As at end-April 2018, for example, the yield to maturity on the Bloomberg AusBond Composite Index (BACI) – Australia’s traditional fixed-rate benchmark bond index – was only 2.7% p.a. Even allowing for an estimated extra “roll-return”* of 0.5% over the following 12 months, the total prospective income from this Index would be 3.2% p.a. That’s no surprise given around one half of this index is comprised of low-returning Federal and State Government bonds.
Due to their higher associated credit risk, corporate bonds can offer higher income returns. That said, one of the more commonly followed corporate bond indices in Australia – the Bloomberg AusBond Credit Index (BACRI) – tends to focus on bonds of relatively short duration, thereby reducing its sensitivity to interest rate changes and hence potential negative correlation with equity returns.
The BetaShares Australian Corporate Bond ETF (ASX Code: CRED)
With these challenges in mind, the BetaShares Australian Corporate Bond ETF (ASX Code: CRED) has been specifically designed with the aim of offering investors superior long-run returns compared to commonly used bond benchmarks such as those described above, but with portfolio diversification properties that are at least as good. CRED seeks to achieve this outcome by targeting corporate bonds – as distinct from government bonds – but specifically those of relatively longer term to-maturity.
The results of this innovative investment strategy are outlined in the table below. As at end-April 2018, the Index which CRED aims to track offered a prospective 12-month income return of around 4.8%, or 1.6% p.a higher than the BACI. And CRED’s prospective income return was also around 0.9% higher than that for the BACRI.
Past or prospective performance is not an indicator of actual future performance. You cannot invest directly in an index.
Note, moreover, the portfolio diversification features. As seen in the table above, a portfolio with a 50% weight to CRED’s Index and a 50% weight to the S&P/ASX 200 Index over the most recent ten years would have actually resulted in slightly less return drawdown than either the BACI or BACRI. That’s despite the fact that CRED’s Index standalone return drawdown would have been somewhat higher. Note, moreover, including CRED in a portfolio alongside equities would have produced even less return drawdown over this period than if 50% of the portfolio had been invested in one-month term deposits instead.
All up, to the extent the past negative correlation between interest rates and equities might persist into the future, CRED seems likely to offer potential diversification benefits in an equity heavy portfolio at least as good as other commonly used bond benchmarks, whilst offering potential for more attractive long-run returns.
*Roll returns stem from the fact that the value of a shorter maturity bond is less sensitive to interest rate changes (i.e. has less interest rate risk) than a longer maturity bond and so, all else constant, usually trades at a lower yield. By taking the risk of holding a bond over a given period, say one year, and allowing its maturity to shorten, investors are rewarded by a lift in its price, known as the “roll return”.
**Specifically, CRED aims to track the Solactive Australian Investment Grade Corporate Bond Select TR Index, which includes investment grade corporate bonds (i.e. with a credit rating of BBB- or better) denominated in Australian dollars with remaining terms-to-maturity of between 5 and 10 years.