SMSFundamentals | Mar 29 2012
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
For an introduction and story archive please visit FNArena's SMSFundamentals website.
The following story was first published for subscribers on March 15.
By Greg Peel
In FNArena's SMSFundamentals series I have often referred to the old fashioned “balanced portfolio” which was once the fund manager's vanilla benchmark. The simplest balanced portfolio was allocated on a ratio of 60:30:10, representing equities, fixed income and cash, and was considered the right “balance” of risk and reward for the average Joe and his super.
The balanced portfolio largely went out the window in the noughties equities boom as consecutive returns of 20% pa or more encouraged investors into shares, shares and more shares. This boom coincided with the rise of the Self Managed Super Fund in this country, but unfortunately it all came a cropper in 2008 and stock market investors have been stung once or maybe twice again in the interim.
The response of SMSF trustees, or smurfs as we call them, has largely been to run away, taking advantage of competition for deposits between Australian banks and subsequent solid yields on term deposits. The result is historically high levels of cash being held in investment portfolios. The annual SPAA survey released last month showed an average of 43.5% equities in smurf portfolios and 25.6% in “cash”, which could include term deposits, cash management trusts, and maybe even banknotes under the mattress for all we know.
The remaining proportion is spread across a wide range of asset classes but there is no concentration in anything else “traditional”. Direct residential property? Only 4.5%. Listed local REITs, some of which have been providing substantial yields? Just 2.5%. And good old-fashioned fixed income, which should supposedly make up 30% of a “balanced portfolio”? A mere 4.7%. (See Cash Is King, Survey Finds)
Analysts have lately been screaming from the rafters that given still large discounts to net tangible asset value, many quality A-REITs are offering not only a solid yield but upside potential as well. But if we cast our minds back to 2007 we recall that investors in REITs were not just burnt, they were incinerated. Clearly it takes time for the nightmares to stop.
In reality, smurfs would have missed quite an opportunity if they hadn't taken advantage of high-interest term deposits from the local banks. We have since had two rate cuts from the RBA, which tend to flow immediately into lower rates for new term deposits, and we also now have local banks which are capitalised comfortably in excess of new international requirements. Deposits as a ratio of Australian bank capital have grown from 40% in 2008 to 50% today. In the same period, short term debt (bank bill issuance) has fallen from 30% to 20% and long term debt (4-5 year bonds) has plateaued at 20%. The reduction in local and offshore borrowing from Australian banks has reflected the elevated cost post-GFC, which again became elevated last year due to the European crisis.
Only the brave would suggest the European crisis is now over, but certainly it has eased. In the recent local reporting season, analysts were surprised by the erosion of bank net interest margins. This erosion reflects a still weak lending market, but also reflects the cost to banks of competing on term deposit rates. The question is: How long will these elevated deposit rates persist? Even if the RBA does not cut again anytime soon, there is no reason why banks can't trim back those rates to improve margins now that the race for capital rebuilding is largely over.
The risk thus is that it may not be long before your next term deposit rollover takes you to a level of interest which is not quite so attractive, particularly after tax. This may encourage a return to the stock market – yields on the shares of the same banks offering term deposits are much higher and full franked, for example – but then it may still be a while before investors feel truly confident to return to the share market in a big way, and that's fair enough. But the risk is that high cash levels in smurf portfolios act as a drag on the growth required to carry smurfs into retirement and beyond.
Why does the traditional “balanced portfolio” contain 30% fixed income? The 10% cash component is also a risk offset against equities, but really it's more of an easy access “slush fund” to facilitate portfolio reallocation. The problem with fixed income is that it is not so easy to get in and out. If you buy a ten-year bond from the Australian government, well you pretty much have it for ten years unless you can find someone else to buy it from you. And they are not cheap on a face value basis.
Yet investors looking to offset the risk of equity investment in an investment portfolio, without removing too much of the growth potential, would do well to note the following chart (provided by BlackRock):
The chart covers the period from October 2007 to October 2011 and compares the 12-month rolling return on the ASX 200 with the equivalent on the UBS Composite Bond Index. The UBS Composite Bond Index is currently comprised of a portfolio of Australian government (35.2%) and state government (31.3%) bonds, foreign sovereign and supranational (more than one country) bonds (18.3%) and Australian and foreign corporate bonds (15.1%).
It is not hard to appreciate, looking at the chart, that over this very volatile period in global financial market history, this fixed income basket has acted as a very good foil for equity performance. Yet if you were to “buy” this index today, you would be yielding 5.65% (running) and 4.79% (to maturity of 3.76 years).
Those numbers stack up pretty well against you term deposit. But they do change as the value of the basket moves which is why the chart rocks and rolls. A term deposit is simply fixed income for a term (six months usually) at a fixed price. Bonds provide the potential for capital gain and loss in a counter to equities.
Which sounds very appealing, but for the inherent problem in investing in bonds in this country. They are (a) often large minimum face value investment required, perhaps $500,000 for example, and (b) no secondary market accessible for retail investors, meaning you're pretty much stuck with them (except for listed corporates, but they can be very illiquid). Such problems are overcome by institutional fund managers who can buy “in bulk” and access intrabank over the counter markets, and hence to invest in fixed income in Australia you realistically have to buy into a managed bond fund with all its inherent fees and commissions. And by definition, that's exactly what smurfs are trying to avoid.
That is, until now. It's been a long time coming, much to the frustration of potential issuers, but Australian regulators have given the green light to local fixed income exchange-traded funds (ETF) and the first of these have been listed on the ASX.
SMSFundamentals introduced EFTs and their characteristics in Active, Passive And ETFs, and Exchange Traded Funds Part II. These articles concentrated on equity ETFs and the benefits they provide in terms of easy access, low costs, and liquid markets for continuous entry and exit for the retail investor. Now that fixed income ETFs have been launched, a whole new world of simple portfolio allocation has opened up for the smurf or any other retail investor.
In a fixed income ETF, it is the manager who worries about buying the underlying bonds in the ETF's portfolio and rolling those over at maturity. The investor buys the ETF just as one might by BHP shares, and can sell at any time. Interest payments on the bonds in the ETF portfolio are accrued and paid to the ETF holder on a quarterly basis, even if bonds in the portfolio pay only annually or semi-annually. When a holder sells that ETF they receive the value of the accrued interest owing to that date.
As is the case with any dividend-paying share, the level of yield on a bond ETF is determined at entry point and remains fixed until the ETF is sold. While the coupon on a bond is fixed (or fixed as a margin over some benchmark), the secondary market will buy and sell those bonds and the demand and supply equation will mean changes in price. The more popular those bonds are, the higher the price, which will mean the next buyer receives a lower yield at entry. Hence the value of a bond ETF will rise and fall similarly. If one buys a bond ETF at a certain price, locking in a certain yield, and the price of that ETF rises, the buyer can then sell that ETF for a profit.
The most obvious cause of a rise in the price of sovereign bond is a cut in the central bank cash rate. If you enter into a term deposit today at say 5.5% for six months and the RBA cuts its cash rate twice in that period well then you're laughing, but only laughing for six months until your rollover takes you down to 5.0%. If you buy a listed fixed income ETF on a running yield of 5.5% under the same circumstances, the yield for the next man on that ETF may fall by 50 basis points but you gain on the offsetting increase in price. If you choose to sell, you collect that profit. Or you may just hold on to your ETF and continue enjoying your entry yield. ETFs run continuously.
Think of it in terms of Telstra shares (prior to separation), which given the fixed nature of their dividend and the government-like ownership of infrastructure are not unlike a bond. When Telstra shares traded well under $3.00 there were yields on offer in the order of 14%. Telstra shares have now rallied to above $3.00 and the yield is more like 9% if you buy today, but if you bought under $3.00 and wish to sell well obviously you have made a capital gain on the share price, as well as having collected the yield over the period.
A bond, or fixed income ETF, works the same way. And buying a fixed income ETF is as easy as buying Telstra shares, whether you act through a broker or online. ETFs are available in low face value units, so no concerns about having to over-commit capital. The only difference is that an ETF of any nature contains a small, embedded management fee (usually in the order of 0.25%) which is included in pricing. Otherwise the cost is brokerage, just like shares.
That management fee may seem off-putting, but as I suggested in earlier ETF articles ETF managers do not offer such products out of the mere kindness of their hearts. And remember that if you were to go out and try to buy the bonds in an ETF portfolio yourself you'd run into all sorts of problems – very large minimum cost, no retail secondary market and, perhaps most importantly, the potential for what market there is to “freeze”.
We recall that when Lehman went under in 2008, the expression GFC was born. Prior to that we spoke only of the “credit crunch” which later became a “credit freeze”. The big problem in this credit freeze is that holders of bonds and other debt had a lot of difficulty buying or selling or finding a price to buy or sell at, and buy-sell spreads, if they even existed, were as wide as the ocean. Investors were stuck, and potentially losing money fast.
Fixed income ETFs have existed in the US for some time. In the US, as is the case now in Australia, there are intermediary firms such as investment banks who commit to making markets on ETFs, come hell or high water, and there are several committed for each ETF listing. In the crucial period of September 2008, when Lehman went down, physical debt markets froze but ETFs kept right on trading. Nor did the bid-offer spread on ETFs widen substantially, which again is an important factor to consider.
If you were to manage your own fixed income portfolio, you would need to roll over maturities and perhaps adjust your ratios which would have you buying and selling various bonds over time. Every time you made a change you'd have to cross a bid offer spread, and thus lose a little more money. But if you buy an ETF, it is the manager behind that ETF worrying about such problems. You are just receiving units of a price index and relevant distributions. The portfolio is initially established and market makers then buy and sell units in that same portfolio in a secondary market (in this case the ASX). The bid-offer spread remains relatively consistent, and tight.
This again is how ETFs act very much like shares, even if they're fixed income ETFs.
The object of any self-managed super fund is to provide a mixture of growth and income on a comfortable risk-reward balance. The young smurf has less desire for income and more desire for growth. The retired smurf needs a lot more income, but must also have growth lest the increasing cost of age erodes remaining value. Equity provides the greatest opportunity for growth but is the most risky, as evidenced by the last four years. Cash provides the greatest safety and known income, but no growth.
Fixed income provides for solid income and the potential for growth. That growth potential, however, occurs as an inverse to equity. As the above growth shows, returns on bonds improve when returns on equities fall and vice versa. So let's go back to our old “balanced portfolio”. The “balance” for the longer term investor comes in the ratio of 60% equities to 30% fixed income. The 30% provides known income and will counter the value lost if equity prices fall. If equity prices rise, the income remains the same but value is lost on bonds. Hence a mixture of the two to balance risk and return.
Of course 60:30 is not set in stone, and a smurf can balance his or her portfolio to suit risk-reward tolerance, as well as including other asset classes such as property or whatever alongside cash holdings. What fixed income does is provide an alternative portfolio constituent which, particularly given the experience of the last four years, can help smurfs sleep at night.
At this point I must extend my thanks to BlackRock, manager of the iShares group of ETFs, for an insightful presentation on the nature of fixed income ETFs. BlackRock's iShares funds represent 60% of total of global fixed income ETFs.
What Fixed Income ETFs Can I Buy?
BlackRock has listed three of the first ever Australian fixed income ETFs this week in the form of the iShares UBS Composite Bond ((IAF)), the iShares UBS Treasury ((IGB)) and the iShares UBS Government Inflation ((ILB)).
These ETFs replicate the portfolios used by UBS to benchmark bond performance and endeavour to track the prices of those indices. Tracking error on replication has to date been negligible. I introduced the Composite Bond Index earlier in this article so for the purpose of this and the other other ETFs I'll reiterate.
The Composite Bond ETF holds a portfolio of 106 securities made up of Australian government bonds (35.2%), Australian state government bonds (31.3%), foreign sovereign and supranational bonds (18.3%) and domestic and foreign corporate bonds (15.1%). At listing the ETF offered a 5.65% running yield and a 4.47% yield to maturity of 3.76 years modified duration. The management fee is 0.24%, embedded in the price.
Note that “running yield” is the net of the coupons on the bonds grossed up based on the price of the bonds at the time, which could be above or below face value. As a bond approaches maturity the price gap to face value will always close such that the “yield to maturity” represents what the holder will achieve by holding to maturity. The “modified duration” represents a netting out of the maturities of the bonds in the portfolio.
An ETF doesn't mature, however. The manager of the ETF simply rolls over positions in the portfolio. So realistically there is only ever a running yield so the yield to maturity is not relevant beyond a means of comparison. An important point to note, however, is that the manager will rollover into new bonds that maintain a consistent modified duration. The longer that duration, the greater movement in price will be experienced by an event such as an RBA cash rate change (because you are discounting more coupons out to time). Hence there is a trade-off to consider between yield and potential for capital gain/loss when choosing a fixed income ETF or portfolio of ETFs.
The iShares UBS Treasury ETF contains 100%, AAA-rated Commonwealth government bonds. On listing this portfolio of 18 different bonds showed a running yield of 5.13% and a yield to maturity of 3.76% for 4.10 years modified duration. The management fee is 0.26%.
The UBS Government Inflation Index Fund reflects the value of sovereign inflation-adjusted instruments. Such instruments are used purely as a hedge against inflation and thus are comparable to the Reserve Bank's core measure of inflation, which at present has settled around 2.5%. Note that the value all financial assets (stocks, bonds, property, but not gold) is eroded by inflation over time.
The iShares UBS Government Inflation ETF contains 10 securities, including Commonwealth government (72.7%) and state government (27.3%) issues. On listing it showed a real running yield of 2.25% and a real yield to maturity of 1.45% for 9.03 years modified duration. The management fee is 0.26%.
If you are looking at these numbers and thinking they are piddling, you are missing the point of “real” rates. Your 5.5% per annum term deposit has a “real” yield of 3.0% after subtracting 2.5% inflation and may only has a duration of six months or less.
BlackRock currently lists the most number of ETFs on the ASX across a range of assets and this week's three fixed income ETFs add to the iShares suite. Russell Investments manages two previously listed equity ETFs, the Russell High Dividend Australian Shares ((RDV)) and the Russell Australian Value ((RVL)). This week Russell Investments also listed three new fixed income ETFs.
They are the Russell Australian Government Bond ((RGB)), the Russell Australian Semi-Government Bond ((RSM)) and the Russell Select Corporate Bond ((RCB)). The names should provide clues to their portfolio make-up.
Amanda Skelly, director of ETFs at Russell, expects fixed income ETFs to be popular with SMSFs and those financial advisors who would like to put their clients into a fixed income allocation but can find no easy way to access the Australian bond market. Australian financial advisors find themselves, according to the aforementioned SPAA survey, most often advising on two particular local asset classes – cash investments (72.9%) is one, which is hardly unsurprising at present, but the other is fixed income (76.8%). This is not really a surprise either, given that since the GFC smurfs have desperately been looking for ways to diversify the risk in their portfolios. To date that market has been all but inaccessible beyond managed funds. But as of this week, it's all become a lot easier.
Please note that BlackRock provides an online educational series on ETF investment on its website.
And as always, FNArena strongly recommends, even though ETFs can be purchased online as easily as shares, that potential investors seek advice from their broker or financial advisor before making such investments and ensure a full understanding of the products.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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