Generating retirement income used to be relatively easy. Government bonds and term deposits (TDs) provided solid yields with relative safety. But with interest rates at historic lows, those traditional building blocks of a retirement portfolio are unlikely to cover all the essential living costs like food, energy and healthcare.
Rates are likely to remain low for the foreseeable future, which creates a predicament for advisers and investors who want solid income from low-volatility assets.
Corporate bonds, which seek to generate consistent monthly income greater than government bonds and TDs, have therefore become an imperative for retirement portfolios. However as corporate bonds are essentially loans to companies for an agreed time and interest payment, they carry higher risk than cash and TDs.
Domestic and global economic downturns can hurt corporate bonds, as well as interest rate movements. And when investing in international bonds, exchange rate movements also need to be managed.
But perhaps the biggest risk of bonds is default, where a company fails to make an interest or principal payment, and which can lead to sharp capital losses for investors.
It is vital, therefore, that when investing in corporate bonds, or selecting a corporate bond fund, that you put risk management and capital preservation front and centre. Only through superior risk management can corporate bonds deliver the twin objectives of regular monthly income and capital stability that retirees need.
The most vital risk management tool
The AMP Capital Corporate Bond Fund, as an example, uses several strategies to manage the risks associated with corporate bonds. The holdings are diversified across more than 100 bonds, which spreads the risk of default by a single company.
The Funds invests in defensive industries such as utilities, financials, transport and telecommunications, and we steer clear of emerging markets or other sectors that lack transparency. To manage interest rate changes, we prefer bonds with shorter duration, which are less sensitive to rate movements. (Longer duration bond prices typically fall more heavily as rates rise.)
We also have flexibility: in times of market stress we can lengthen our interest-rate duration, and we can use credit default swaps to hedge against potential losses.
But the single most important way we manage risk is through a rigorous focus on quality.
At least 90 per cent of the Fund is investment-grade credit (rated BBB – equivalent to Moody’s BAA rating – and above) issued primarily by Australian companies.
Some of these quality Australian companies include ANZ, NAB, Telstra, Qantas, Wesfarmers and Westpac. We also invest in some international companies including Coca Cola, Nissan, Toyota and Intel.
It’s important to be aware that although high-yield issues can be attractive, they carry a far greater risk of default. We therefore limit the Fund’s high-yield holding to less than 10 per cent of the portfolio.
As you can see in the chart above, the risk of default also increases with the length of maturity (the time held before a bond’s principal is paid back to you). A BBB rated security with a 7-year duration is a lot riskier than a BBB rated security with a 2 year duration. When it comes to duration, we focus on corporate bonds with a duration of around 2.5 to 3 years on average.
Earning the conviction to hold/buy
The bedrock of our focus on quality, and our ability to avoid default, is deep, fundamental credit research. We are the largest credit manager in Australia, and our team of 35 investment professionals around the world has an average of 15-years’ experience.
That structure gives us the insight and knowledge to hone in on corporate bonds of – sometimes hidden -- quality, and gives us the conviction to hold them to maximise results.
For example, back in 2015, Glencore’s shares and bonds were under a cloud. The company, which is listed on the London Stock Exchange with a market capitalisation of 17 billion pounds, is one of the world’s largest, global diversified mining groups. But slumping commodity prices and broader underperformance across the metals and mining sector rattled the market. Investors also fretted about Glencore’s debt load and short sellers targeted the company.
Glencore’s shares and bonds suffered; its bond spreads (the difference between its yield and government bond yields) widened.
But we were able provide a level of foresight that meant we were confident that Glencore was in a stronger position than the market suggested.
We could hold with conviction Glencore Australia Holdings’, a wholly owned subsidiary of the UK parent company, bonds which mature in September 2019 and that pay a fixed coupon with a 4.5 per cent rate.
The market has since been able to absorb what we saw, and it has recognised Glencore’s improved credit metrics, strong cash flows and robust balance sheet.
Glencore has been aggressively reducing debt by cutting operational costs. It has also cut dividends, sold assets and raised equity capital. With $13.5 billion in cash and undrawn facilities, and just $5 billion of bonds to refinance a year, Glencore has a strong liquidity profile to withstand market volatility. That liquidity will continue to improve as the company generates more positive free cash flow.
The company’s bonds rallied significantly in the past year, aided by an uplift in commodity prices.
Delivering retirees’ goals
The rigorous investment process has allowed the Corporate Bond Fund to deliver consistent monthly income even in times of market turbulence.
By focusing only on quality corporate bonds, the Fund delivers on the major goals of retirees: providing a consistent, predictable monthly income that they can rely on with confidence, along with capital preservation.
As with all investments there are key risks to consider. Please refer to the PDS for further information.
Important note: All information in this article is current as at 30 April 2017. Investors should consider the Product Disclosure Statement (“PDS”) available from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (“AMP Capital”) for the AMP Capital Corporate Bond Fund (“Fund”) before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (“AMPCFM”) is the responsible entity of the Fund and the issuer of units in the Fund. Neither AMP Capital, nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this article. Past performance is not a reliable indicator of future performance.
While every care has been taken in the preparation of this article, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to their objectives, financial situation and needs.