Opinion: Should fixed income investors hold coupon reset securities?

Over the last 12 months a wide range of market participants have frequently asked us about our approach to investing in reset securities.

Sometimes the question relates to a specific security, sometimes to the sector more generally.

It is clear that many investors are disappointed at the performance of some of these securities and are unsure of what role reset securities play in a fixed interest portfolio.

In this note we review the performance of reset securities, assess their volatility and correlation, and use this analysis to illustrate the role they might play in various types of investor portfolios.

A key conclusion of our research is that reset securities have behaved more like equities than high-grade bonds.

In our opinion, these characteristics suggests that they can only play a limited role in the core fixed income section of a balanced portfolio, where the aim of fixed income is to provide capital security and offset the volatility inherent in equity markets.

A somewhat larger exposure may be justified in an income-focused portfolio.

Performance varies significantly amongst individual NZ reset securities. Large exposures to individual securities can be risky.

A more prudent approach is to limit individual reset positions after considering their volatility and correlation factors. Any holdings need to be motivated by attractive valuations relative to fundamentals. 

The term ‘reset securities’ is used loosely in New Zealand to capture a range of debt securities where the coupon may be reset at some time prior to maturity.

Some have a fixed program of resetting the coupon annually, whereas others are ‘reset’ if a call option is not exercised by the issuer and the security remains in the market. There are a range of combinations, with most securities having their particular idiosyncrasies.

Note:  Peer group of nine reset securities.  Sample period March 2008 to March 2012.

NZ reset securities

We chose nine reset securities to analyse, which we believe are broadly representative of the securities available in this sector of the New Zealand market. All trade on the NZDX or NZX (ASBPA is on NZX) and are widely held by retail investors. Most are perpetual (no fixed maturity date) but there are specified dates where the issuer has the right to call. Most rank subordinate to senior obligations of the issuer.

We built an equal-weighted index (the Reset Group) of the nine securities in order to analyse their collective behaviour.

Source: Bloomberg, Harbour Asset Management

Performance of reset securities

Issuance of reset securities was plentiful from September 2007 to February 2008. This was the period immediately after the Bear Sterns failure but before the GFC really gained momentum. Global credit spreads were just starting their move wider from extremely tight levels.

We have analysed monthly data from March 2008 – March 2012. As a group, reset securities underperformed NZ Government Stock from March 2008 – March 2012, as shown below. This incorporates the (pre-tax) coupons from Government Stock and the Reset Group. Performance has diverged considerably across securities. Only ANBHA and BISHA have kept up with Government Stock returns.

Volatility of reset securities

Levels of volatility have also varied noticeably across individual securities. We have measured these by the standard deviation of monthly price changes and maximum 3 month absolute percentage changes in price.

Some securities have displayed particularly high volatility and large total 3 month price moves. CASHA, OCFHA, ASBPA, RBOHA and SKTFA are in this group. These securities have shown a tendency to display material price movements over time. Movements have been both up and down in price terms. Over the first 3 months of 2012, CASHA, OCFHA and ASBPA have generated respective returns of 38.5%, 13.7% and 12.6%. In each case, this follows periods of even greater falls.

Considering each security individually, there have been specific causes for the relative performance differences. CASHA and RBOHA have had European and financial sector concerns; QHLHA and SKTFA have been less affected because they are senior ranking; CBAFA and SKTFA benefit from a known maturity date.

Correlation of reset securities with bonds and equities

In addition to their volatility, another key characteristic is the correlation of reset securities – to each other, and to other asset classes like high grade bonds and equities.

The chart below illustrates that the correlation amongst reset securities is relatively high in some cases, typically ranging between 40-60% correlation with the reset group.    
Their prices have fallen during episodes of stress like the GFC and European sovereign crisis, and recovered when pressures abate.

More importantly, a key conclusion of this analysis is that reset securities have behaved more like equities than high grade bonds.

This makes them much like the high yield bond sector traded in offshore markets.  

While NZ investors familiar with these securities may find this outcome unsurprising, few would have expected this behaviour when the securities were initially sold.

Indeed, CBAFA, ANBHA and BISHA were the only reset securities that had a positive correlation with the Corporate A-Grade Bond Index. All the others were both positively correlated with equities and negatively correlated with corporate and government bond returns.  

Role of reset securities in a portfolio

So what role might there be in a fixed interest portfolio for securities that can display considerable volatility and are negatively correlated with high grade fixed income securities?

Our view is that the appetite depends on the investment objective of a given fund and what role it plays in the overall investment portfolio of an investor.

Balanced portfolio

In a balanced portfolio, where the primary objective of fixed income is to provide an offset to the inherent volatility of equities, the argument is to have little or no reset exposure.

A large exposure could undermine the stability-providing characteristics a high grade fixed income portfolio can provide.  

However, we can make an argument for a small exposure where holdings are motivated by fundamental analysis and attractive valuations. We believe research-focused fund managers can identify security specific opportunities in these securities.

As reset securities display negative correlation with NZ government stock, a long reset position can be likened to a short duration position. Therefore, one needs to be mindful that resets are not just a proxy for a short duration position. A more efficient way of expressing that investment view would be to use swaps or government bonds, given their lower transaction costs.  

Despite this, we still see valuation based opportunities, particularly as these may be driven by retail-driven sentiment in a market where investors may lack research skills.

Income Portfolio

For investors where the growth asset weighting is smaller and the emphasis is on capital stability and income generation, there can be an argument for a somewhat higher allocation to resets.  

Provided the reset sector offers compensation for its additional volatility, the fact that the reset securities are not perfectly correlated with each other offers some prospective benefits. However, we would still argue for a relatively low overall weighting and, in particular, a small individual exposure limit. The security-specific risks and subordinate ranking of most reset securities provide an additional rationale for a conservative approach.

For retail investors, these concepts also apply. However, we would add the caveat that it is difficult to construct a portfolio with sufficiently small positions in resets to contain the security-specific risks to a tolerable level. In addition, the security research task is demanding, given the subordinate ranking and security peculiarities that abound in this sector.

We also note that in the extreme, where a retail investor’s fixed interest assets are concentrated in reset securities, the investor’s portfolio may be riskier than assumed and therefore not be an appropriate match of their personal risk profile.

Approach to resets at Harbour Asset Management

At Harbour Asset Management, we manage two fixed interest funds. 

The NZ Core Fixed Interest Fund is designed to be a ‘core’ fixed interest exposure and to provide the return characteristics desired as part of a balanced portfolio. The NZ Corporate Bond Fund, by virtue of its focus on corporate debt, has a greater focus on income generation with some scope for capital gains.

Each fund has its own limits on aggregate and individual holdings of securities, to reflect the distinct style and objectives of the funds.

Aggregate limits

In the NZ Core Fixed Interest Fund, we constrain total exposure to all subordinate and perpetual securities to a maximum 10% of the Fund. In the NZ Corporate Bond Fund, we have a maximum 20% exposure to subordinate and perpetual debt, which includes a 10% maximum to perpetual securities.  

Note that reset securities are only a subset of this category; other types of subordinate debt exist. It is also very important to emphasise that they are maximum exposure levels, not targets. Typically we would expect to sit well inside these constraints.

Individual securities

Reset securities share the issuer exposure limits that apply to all securities. However, the analysis in this paper does provide us with internal guidance on the size and composition that maximum individual holdings might take.  For example, we consider individual security volatility, maximum 3 month price volatility and historical correlations with other asset classes like equities and high grade bonds. 

We are aware that these statistical measures are no more than historical observations and that this does not imply future performance will be consistent with the past. Accordingly, fundamental credit analysis also plays an important role. Again, it is important to highlight that this framework is for guidance on maximum holdings, not targets. Any actual holdings need to be motivated by attractive valuations relative to fundamentals.  

This research has enabled us to review our framework for maximum holdings of reset securities. Our revised approach is outlined in this table.

Source: Bloomberg, Harbour Asset Management

Conclusion

Over the last 12 months we have frequently been asked, by a wide range of market participants, about our approach to investing in reset securities.

To answer this question, requires a strong understanding of the motivations of the investor – whether in a balanced or income portfolio – and the characteristics of reset securities.  

A key conclusion of our research is that reset securities have behaved more like equities than high grade bonds.    

Reset securities can play a role for fixed interest investors, particularly in an income portfolio where there is a low existing allocation to growth assets.  However, individual holdings needs to relatively small and diversified, and motivated by research that their valuations are attractive relative to fundamentals.  

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Mark Brown, Director, Fixed Income Portfolio Management
Christian Hawkesby, Director, Head of Fixed Income