Know your bonds, they're not all the same

29 April 2020 | Markets and economy

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In the midst of the COVID-19 pandemic, the agencies that rate the bond issues of countries, government agencies and companies around the world have been working overtime.

In essence, they've been assessing the financial stability of every issuer in the fixed interest market – and the credit quality of the bonds they've issued to raise debt capital from investors – to gauge their ability to meet their repayment obligations.

And what's followed has been a flood of ratings downgrades, reflecting the severe deterioration in economic conditions globally and the flow-on financial effects from the virus outbreak to governments, financial institutions and companies.

Even Australia, one of the few countries in the world still holding the highest credit rating of AAA, hasn't been immune. On 8 April, international credit rating agency Standard & Poor's revised its rating outlook on Australia from stable to negative in response to the economic shockwaves from COVID-19.

A ratings downgrade is not out of the question, if conditions deteriorate even further from where they are now.

As soon as Australia's ratings outlook was revised, the outlooks on every state and territory, every government entity, and every Australian bank (because of their central role in the Australian economy) also were revised to negative.

Credit downgrades increase

Not all governments and other issuers have escaped with just an outlook revision. Many have had their ratings downgraded over recent weeks and the level of defaults on corporate credit repayments has risen.

Investors with direct exposures to these entities via credit bond issues, and equities if they're also listed companies, face losing their capital.

For fixed interest investors, the ratings activity is a timely reminder that the credit quality of bond investments can vary widely. That fact was underscored by the wide variation in returns from fixed interest investments over the first quarter.

Funds with lower-risk profiles – specifically those invested across highly rated sovereigns, supranational entities, federal and regional governments and companies with strong ratings – rallied. On average, they produced significantly better returns than fixed interest funds invested across corporate credit bonds issued by entities lower down the credit quality ratings scale.

Corporate bonds tend to have shorter maturity durations than government bonds and a higher correlation to equity markets.

Ratings and risk

Credit ratings are one of the key drivers for bond markets, because they effectively tell the financial quality story of the entity behind every debt capital issue. As with any investment, higher returns generally translate to higher risk. Bond issuers are no different.

Which is why fixed interest investors should not only have an understanding of credit ratings scales but also be aware of the types of bond issuers that are packaged into different fixed interest products.

Although fixed interest is often regarded holistically as a "defensive asset" class, some issued debt definitely carries higher levels of repayment default risk than others. Products skewed towards bond issuers with "investment grade" credit ratings (AAA to BBB-) generally have a much low default risk profile compared to products with higher exposures to companies with lower ratings.

Governments tend to be at the high end of the credit scale. They have huge financial resources, and have the ability to readily issue new bonds and print money.

Corporates don't have this capacity and are largely reliant on debt funding to build their operations. When cash flows become stressed, as many are currently experiencing, their ability to service their debts is impaired.

Bonds for diversification

Investment grade bonds, because of their primary function as long-term debt funding instruments, are less susceptible than shares to short-term market volatility and provide ballast when equity and credit markets suffer.

If the objective of your portfolio is to build a diversified set of assets that meet your risk-return profile, bonds are still the best asset class to achieve real diversification from equities in times of stress.

While some investors may look to alternative forms of diversification during periods of lower expected returns, most alternative options other than bonds (including real estate, infrastructure and shorter-dated credit) are directly correlated to equities and therefore vulnerable to an equity market sell-off.

While bonds can experience low to negative returns in the event of rising interest rates, the reinvestment of a higher coupon and the benefit of compounding means investors with a medium to long time frame are eventually better off holding bonds.

Global bond funds provide exposure to high-rated government and corporate issues, offering secure long-term income streams over the duration of each bond issue.

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Tony Kaye

Tony Kaye
Personal Finance Writer
Vanguard Australia