Understanding Bonds

Next, we have Renny Ellis, Head of Portfolio Management at Oculus Funds Management.

Renny has been managing capital across fixed income and credit assets for 30 years, working with a range of clients, from individuals to corporations.

He'll be helping us understand the world of bonds with his presentation, Understanding Bonds.

Please join me in welcoming Renny.

Thank you very much, Angelina.

Today we are talking about understanding bonds and I'm not going to pretend, I'm not going to do this subject just fully full justice today.

I'm going to try and hit a few hot points.

Those are the conflicts of information that we receive in the market, bond risks, and if I get time, a portfolio example and MBS risks.

Conflicts that we receive on information in particular are common in this sector.

Chief amongst those is our central bank.

It has a conflicted mandate.

We've spoken about this many times and most of you would be aware of it.

A little less well known is that banks also have a conflict when they're talking about inflation and the need to invest in fixed income and credit market products.

Banks inherently borrow short and lend long.

They are looking for lower interest rates because it does help them.

Also, they don't like high interest rates because it diminishes the asset values upon which they're lending.

The third amongst them is fund managers, and this is something not often realised, is that there are two types of, well, there's three types of fund managers out there.

There's the equity fund managers, and they always like a lower interest rate because it improves the DCF value of a company.

And then there are amongst the fixed income asset class, there are long duration fixed bond managers and there are credit funds.

that hold predominantly floating rate bonds and other debt-like securities.

Iculis is an absolute return manager.

So we're indifferent between long duration and credit funds.

At different points in the cycle, we can move into long duration and other points in the cycle as we are currently 100% floating rate.

Amongst the two conflicting long duration and credit fund managers then, one is currently screaming a recession is imminent,

inflation is under control and the other is yelling that floating rate credit is better because the economy is still robust and inflation remains a risk.

There is however a third problem at the moment.

Credit margins for the floating rate credit margin managers at the moment are very tight.

This is reflective of an economy that is at no risk of suffering a recession.

And there is some recession risk out there that needs to be appreciated.

So I'll talk about that later in the speech.

First, I want to cover off the role of bonds very briefly.

Generically bonds form part of a portfolio because they provide capital stability, consistent income and a source of liquidity.

Fixed rate long duration bonds have not been sufficiently uncorrelated with equities to balance returns for some time.

And that's an important consideration as part of a balanced portfolio.

I must also stress that not all bonds are equal.

There are a range of factors that investors need to understand, and I've listed some of these here below.

But I would like to focus today on one of the main things that we see out there, and that is liquidity.

Liquidity is the most underappreciated and underestimated risk by investors.

In recent times, we've seen a raft of private credit funds raising capital from investors to lend out to companies.

And a lot of this is to property developers that can't access enough bank funding.

ASIC and APRA have also raised this as an issue recently.

Many of these funds are indicating that they will deliver an equity-like return of 10 to 12% with capital stability.

I must stress here that equity-like returns always come with equity-like risk.

There is no free lunch.

These private funds may look like alternative asset class investments, but this is only because the loans are being valued on a whole to maturity basis.

There is no secondary market or independent way of valuing these bonds.

And so investors are not able to get unwind their position until maturity of the underlying securities.

As an example here, I've listed the AustraClear registered bonds that are actively traded in the secondary market.

And even within these bonds, some are more liquid with lower running yields and others are less liquid with understandably higher running yields.

Fixed rate bonds versus floating rate bonds.

It's important to understand how a bond's value can change over its life.

Firstly, consider a 10-year Commonwealth bond rated AAA that has the highest possible credit rating in Australia.

Investors need to understand that a 1% change in the yield on this bond equates to a 9% change in its capital value.

Get the timing wrong on this bond and the return at maturity will equal the issuing yield, nearing 4% at the moment.

But along the way, the mark-to-market value could be deeply negative.

As the chart below shows, there is a risk that asset allocators that shifted funds into 10-year bonds, adding duration generally, on yields maturity below 3%, will never see these bonds trade below this level again, and so they will trade at a capital loss.

On floating rate bonds,

While a move in 1% yields maturity on a fixed rate bond equates to a 9% loss for a 10-year and a 4.5% loss for a 5-year bond, there is also a capital risk in floating rate bonds where a 1% increase in the traded margin over the 90-day bank bill swap equates also to a 9% capital loss.

The margin on a floating rate bond is a reflection of credit risk.

A higher risk bond has a wider credit margin, but even the margin on the major senior bank bond can vary considerably due to the impact of economic shocks.

And in this chart, I show the economic shocks over the past year, of the past 14 years.

It is worth noting here, the amount of time that the ITRAX index, a representation of floating rate margins in Australia, has traded above 100 basis points,

and how often it has traded below a hundred basis points.

And also that it is currently trading near the very low points at around 60 basis points that we have seen over two decades.

Briefly here, I just mentioned in passing the ACLA's fixed income management, which is an absolute return unit fund, not linked to a benchmark.

And as such fixed duration is varied over the economic cycle.

It can invest in sovereign and senior bank bonds that have met the RBA repo eligibility criteria.

These bonds form part of the high quality liquid assets universe that is defined by APRA.

The purpose of the HQLA universe is for all banks to hold enough capital at all times to meet term deposit withdrawals in any 30-day period.

So if HQLA are good enough for APRA, what are they?

They are bank deposits in the RBA exchange settlement account, sovereign bonds, Commonwealth and semi-government, notes and coins and cash.

It's important here to understand how a bank alters its deposit level at the RBA exchange settlement account.

When a bank sells a repo eligible bond to the RBA, the funds are deposited in the exchange settlement account and in doing so increase its HQLA.

The RBA buys bonds from banks daily as part of its open market operations and all repo bonds offered by an ADI on request.

When then,

What then are repo eligible bonds?

They are, the RBA repo facility enables approved banks to select eligible securities for repurchase by the RBA to support improved intraday liquidity management.

In a credit crisis, repo eligible bonds are designed to be able to be cashed at the RBA window daily with funds transferred into each bank's exchange settlement account at the RBA.

These bonds are held and traded liquidly between all banks as part of the daily capital management activities.

So a highly liquid in all market conditions.

It is important to understand then the capital structure of Australian banks.

under the APRA interpretation of the Basel capital adequacy rules.

In practice, we have seen governments in different jurisdictions move to ensure both term deposits and senior bonds.

However, we have never seen this tested by a systemic risk event, only specific bank events.

The following pyramid displays the declining level of risk from common equity, first loss absorption for a bank, all the way down to senior bank bonds.

This describes here the tier one regulatory buffer, 6%, and then the secondary or tier two regulatory buffer, which in Australia is a TLAC requirement at or above 10.5%, 10.25%.

Term deposits follow, and then finally senior bank debt.

I have here just quickly a risk return slide for investors to get a guide for what sort of returns you can expect for that sort of risk.

Under the Basel rule,

rules all term deposits must be held for a minimum of 30 days while bank bonds can be traded in the secondary market and settle at T plus two.

The lower risk nature of a senior bond and greater liquidity should mean that it has a lower return than a term deposit.

However in practice Australian banks offer a 90 day term deposit at bank bill swap plus 70 basis points and a major bank five-year floating rate senior bond trades at bank bill swap

plus 95 basis points.

This difference can be explained by the lack of access to wholesale securities by retail investors and the fact that a 90-day term deposit is traded every day and the return varies every day.

Thank you, Renny.

It's great to see you.

Thank you very much for having me.