Investment Policy Guidelines For building fixed income portfolios

Transcription

1 Investment Policy Guidelines For building fixed income portfolios

2 INTRODUCTORY GUIDE Investment Policy Guidelines For building fixed income portfolios Contents The role of fixed income in your portfolio / 01 Assessing risk in fixed income / 02 Credit risk / 04 Recommended guidelines for fixed income portfolios / 06 Liquidity risk / 08 Reinvestment risk / 10 Reinvestment risk mitigated via investing in securities with laddered maturities / 10 More information / 12 CRAIGS INVESTMENT PARTNERS LIMITED

3 The role of fixed income in your portfolio Determining what proportion of a portfolio should be invested into each asset class cash, term deposits and fixed income (commonly referred to as income assets) and property and shares (commonly referred to as growth assets) - is referred to as asset allocation. Deciding on an appropriate asset allocation is a very important step in portfolio management as how a portfolio is split between the asset classes determines, more than any other factor, a portfolio s risk and return profile. As such, the composition of a portfolio between income and growth assets will depend on an individual s objectives and risk tolerances. The role of fixed income in a portfolio is twofold; firstly to provide a known and reliable income stream and secondly, to lower the risk (volatility) of the entire portfolio. Fundamental to investing in fixed income securities is the return of capital and certainty of income over the term of the investment. However, not all fixed income instruments are created equal when it comes to risk. These guidelines help investors to better understand how to build a fixed income portfolio most suited to their needs. Fixed Income Investment Policy Guidelines / 01

4 Assessing risk in fixed income A key characteristic of most New Zealand dollar fixed income portfolios is that the majority of holdings are bonds issued by corporate Issuers as opposed to the New Zealand Government. These corporate bonds tend to trade at higher yields than bonds issued by the Government and we describe the difference in yield as the credit spread or margin. However, as the saying goes there s no such thing as a free lunch and this opportunity for higher yield does not come without some risk. These guidelines seek to help investors mitigate such risks by building a fixed income portfolio which selects the best combination of bonds taking into account: Credit risk Certainty of receiving the promised interest and principal payments. This also covers different types of securities (most commonly senior and subordinated) issued by the same Issuer group which have quite different risk profiles. Liquidity risk The ability to sell bonds quickly at the expected price. Reinvestment risk If interest rates fall then any maturing funds have to be reinvested at a lower rate. 02 \ CRAIGS INVESTMENT PARTNERS

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6 Credit risk In our view, credit risk is the most important element to consider when selecting fixed income securities. Credit risk is also known as default risk. Bonds issued by corporates have a higher risk of default than those issued by the Government. For this reason credit risk is important to assess when investing in corporate bonds. As part of the assessment of an entity s credit risk we review financial reports and the earnings outlook, and specific to the bond (or issue) the relevant documentation, including any financial covenants. Another key input into our credit analysis is the credit ratings produced by reputable global credit rating agencies. Standard & Poor s (S&P) is the most well-known credit agency in New Zealand although Moody s Investor Services and Fitch Ratings also have a presence here. Rating agencies assign Issuer Credit Ratings and Issue Credit Ratings. In assigning an Issuer Credit Rating, rating agencies evaluate current and historical information and assess the potential impact of foreseeable future events. S&P describe an Issuer Credit Rating as a forwardlooking opinion which focusses on the Issuer s capacity and willingness to meet its financial commitments as they come due. The opinion is not specific to any particular bond issued by an Issuer. An Issue Credit Rating relates specifically to the fixed income security. It is a forward-looking opinion about the creditworthiness of an Issuer with respect to a specific financial obligation. It takes into account the likelihood of payment capacity and willingness of the obligor to meet its financial commitment on an obligation. Issue ratings are an assessment of default risk, but take into account any specific features of the instrument that affect relative seniority or ultimate recovery in the event of default. For example Company A s unsubordinated (senior) bonds will have a higher credit rating than Company A s subordinated bonds. This is because the risk of nonpayment is higher for the subordinated bonds. There is an expectation that investors should be paid a higher interest rate to compensate for the additional risk. So Company A s senior bonds should trade at a lower margin (and for securities of the same maturity, a lower interest rate) than the subordinated bonds. There are some Issuers in the New Zealand debt market who choose not to be rated and generally these would be within the BBB rating bank or lower if rated. 04 \ CRAIGS INVESTMENT PARTNERS

7 The following table shows the rating scales of the three credit rating agencies and the approximate probability of default over time. Strength S&P scale Moody s scale Fitch scale Approx. probability of default over five years* Capacity to make timely payment Extremely strong AAA Aaa AAA 1 in 600 Very strong AA Aa AA 1 in 300 Strong A A A 1 in 150 Adequate BBB Baa BBB 1 in 30 Vulnerability to non-payment Less vulnerable BB Ba BB 1 in 10 More vulnerable B B B 1 in 5 Currently vulnerable CCC Caa CCC 1 in 2 Currently highly vulnerable CC CC Default D C D * The approximate median likelihood that an investor will not receive repayment on a five-year investment on time and in full based upon historical default rates published by each agency. Source: Adapted from Reserve Bank of New Zealand. While a higher credit rating does not remove all risk, investors can be more confident that an Issuer/bond with a strong credit rating is less likely to default than a lower rated Issuer/bond. We use credit analysis from Craigs Investment Partners Private Wealth Research and Fixed Income and the credit rating, where available, to assign each retail debt security a Portfolio Classification of Core, Supplementary or Niche (the same Portfolio Classifications as assigned to equities). A lower credit rating indicates a higher risk that interest and principal will not be repaid on the promised dates. We consider an essential principle of building a fixed income portfolio is ensuring Core securities comprise at least 60% of the dollar value of all bonds. Fixed Income Investment Policy Guidelines / 05

8 Recommended abbreviated guidelines for fixed income portfolios Portfolio classification Exposure to classification Issuer Core Minimum of 60% NZ Government Local Authorities and LGFA NZ Banks rated minimum AA- NZ Banks rated A+ Corporates rated A and above Corporates rated BBB Supplementary Up to 40% Core as above Other Financials and Investment Grade Corporates (non-core)% Niche No more than 20% of a portfolio Core and Supplementary as above All others S&P credit ratings used in the above table. In order for a security/issue to be considered for classification as Core, the security terms must include: > A ranking of senior (secured or unsecured), guaranteed or unsubordinated; > An investment grade Issuer Credit Rating from at least one of the three major credit rating agencies; > A requirement to pay interest on regular and known dates; this includes unsubordinated floating rate notes which pay a coupon set every 90 days over the bank bill rate plus a fixed margin; and > A fixed maturity date on which the principal is repaid. Other securities, will generally be classified either Supplementary or Niche. These include the remaining unsubordinated bonds on issue, subordinated bonds, hybrids including capital notes, capital bonds and preference shares, many of which will have quite different risk characteristics. The attributes of these securities are likely to include one or more of the following: Imputed dividends rather than interest coupons; Interest coupon (or dividend) resets usually at a set margin over a stipulated benchmark such as bank bill, bank interest rate swap or government bond with the same maturity as the period the interest coupon is set; 06 \ CRAIGS INVESTMENT PARTNERS

9 Ability for the Issuer to cancel or temporarily defer interest payments (or dividends); Perpetual instrument with no maturity date and the option to call and redeem lies with the Issuer rather than the investor; The Issuer has the option to issue shares to the value of the principal component rather than pay cash to redeem the securities; and Loss absorption where, under certain circumstances, bank Issuers have the right to write off some or all of the principal and interest. Just as with equities we recommend diversification of names within portfolios to reduce risk. In addition, we suggest investors ensure they have a mix of financial and non-financial Issuers within portfolios. Compared with Core securities other instruments, particularly those classified as Niche, are likely to have a lower correlation of price movement to interest rates and in times of stress to behave more like equities. Companies often have a number of different series of debt on issue at any one time and they use the retail debt markets to ladder their borrowings and to issue subordinated securities which rank behind senior debt, including borrowings from banks. The following diagram provides an indication of how the investments can be selected using the table on page 6 according to risk tolerances. Illustrative Fixed Income Portfolio Structure CORE INVESTMENTS 60% NICHE NICHE INVESTMENTS 15% CORE SUPPLEMENTARY SUPPLEMENTARY INVESTMENTS 25% Classification Range Core 60% - 100% Supplementary 0% - 40% Niche 0% - 20% Fixed Income Investment Policy Guidelines / 07

10 Liquidity risk We define liquidity as the ability for a seller to find a buyer in a short time period without the sale adversely affecting the price. In New Zealand, the most liquid securities are issued by the Government and New Zealand Local Government Finance Authority (LGFA). They are issued in large volumes and both enjoy the highest domestic Issuer Credit Rating of AA+ from S&P. In aggregate, there is over $60 billion on issue of these securities and unsurprisingly these securities have a very low liquidity risk. We estimate the value of all other bonds available to retail investors to be much smaller at circa $22 billion. This comprises over 30 corporate and financial Issuers and, because many have more than one bond issue outstanding, approximately 140 individual securities. Around 80 of these are listed on the NZX Debt Market and trade on-screen. This provides publicly available buy and sell quotes and details of the price and volume submitted by NZX Participants, although institutional trading, if any, is not visible.... we assign considerable importance to being able to exit a security relatively easily... We have identified a number of investment-grade credit rated senior and unsubordinated bonds (classified as Core) which have a low liquidity risk. These are transacted in what is known as the over-the-counter market which is largely institutional comprising banks and institutional investors, although NZX Firms are also participants. Some of these will be listed on the NZX Debt Market although the volume traded here is likely to be a small subset of all activity. These securities are relatively liquid i.e. a buyer can be found quickly at a fair price. However, there are other debt securities where the NZX Debt Market is the principal trading mechanism. Such securities tend to be subordinated (i.e. ranked below senior debt in any liquidation), have a below investment grade credit rating, if rated (i.e. an Issue Credit Rating of BB+ or lower) or be unrated. These securities are predominantly traded by retail investors and prices are largely driven by demand and supply. This can result in wider spreads between the bid and offer and a lower correlation between interest rates and price movement than for bonds traded in the institutional over-thecounter market. Within Craigs Investment Partners internal classification system, we assign considerable importance to being able to exit a security relatively easily and those securities, with potentially low liquidity, are generally assigned as Supplementary or Niche with lower indicative weighting levels. 08 \ CRAIGS INVESTMENT PARTNERS

11 We recommend managing these risks by limiting exposure at individual Issuer and issue level, diversifying amongst sectors and laddering maturity dates. Bonds are considered to be income assets and generally should have a lower risk profile than growth assets. However, fixed income encompasses a wide range of securities - some with equity-type characteristics. These guidelines are intended to explain some of the risks within the asset class and help investor s structure portfolios according to their objectives and risk tolerances. We recommend managing these risks by limiting exposure at individual Issuer and issue level, diversifying amongst sectors and laddering maturity dates. A conservative investor seeking to lower the volatility of the total portfolio would only be required to hold a small number of Core bonds. However, we recommend an investor requiring income and investing in Core, Supplementary and possibly Niche securities hold a greater number of individual bonds. Fixed Income Investment Policy Guidelines / 09

12 Reinvestment risk The risk that coupon payments of interest and maturing principal have to be reinvested at a lower interest rate than the current investment. We mitigate this risk by laddering investments by maturity date. This means in any given year only some of the portfolio will mature and need to be reinvested. If securities have a resetting coupon we use the next interest rate reset date as this is similar in its effect as a reinvestment. By managing reinvestment risk the portfolio provides a more stable and known flow of income. Reinvestment risk mitigated via investing in securities with laddered maturities Nearer of interest rate reset or maturity date Minimum Maximum Up to including 1 year 10% 40% Above 1 year and up to 3 years 20% 40% Above 3 years and up to 5 years 20% 40% Above 5 years and up to 7 years 10% 30% Above 7 years 0% 10% We note securities that have an early call feature increase an investor s reinvestment risk as corporates may repay earlier than the maturity date and are more likely to do so in a declining interest rate environment. 10 \ CRAIGS INVESTMENT PARTNERS

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14 Speak with us to learn more. For more information on building a Fixed Income Portfolio contact your Investment Adviser. Research reports on each debt security are available on our website within the client portal. Talk to your Investment Adviser today or visit craigsip.com 12 \ CRAIGS INVESTMENT PARTNERS

15 Disclaimer: This report is a private communication to clients of Craigs Investment Partners Limited ( Craigs Investment Partners ) resident in New Zealand and is not intended for public circulation or publication or for the use of any third party, without the express prior approval of Craigs Investment Partners. This communication is not intended for distribution in the United States or any other jurisdiction outside of New Zealand. While this report is based on information from sources which Craigs Investment Partners considers reliable, its accuracy and completeness cannot be guaranteed. Craigs Investment Partners, its partners and employees, do not accept liability for the results of any actions taken or not taken upon the basis of information in this report, or for any negligent mis-statements, errors or omissions. Those acting upon information and recommendations do so entirely at their own risk. Craigs Investment Partners and/or its partners and employees may, from time to time, have a financial interest in respect of some or all of the matters discussed. The research analyst or analysts responsible for the content of this research report certify that: (1) the views expressed and attributed to the research analyst or analysts in the research report accurately reflect their personal opinion(s) about the subject, securities and Issuers and/or other subject matter as appropriate; and (2) no part of his or her compensation was, is or will be, directly or indirectly related to the specific recommendations or views contained in this research report. An analyst who participated in the preparation of this report, or a prescribed person of that analyst, has a shareholding/financial interest in companies discussed in this report. Please note that any advice in this report is class advice and that your personal circumstances have not been considered when providing you this advice. You should, before acting on such advice, consider the appropriateness of the advice, having regard to your relevant personal circumstances and financial objectives. Fixed Income Investment Policy Guidelines / 13

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