Craig Simpson provides some thoughts and tips for DIY bond investors

By Craig Simpson

I have a particularly biased view on why people should engage financial advisers as I have spent my entire working life in and around the financial advisory industry. Despite this, I appreciate some people prefer the good old “do-it-yourself” (DIY) approach and prefer to trust themselves to manage (or lose) their own money.

For those with a passion for DIY investing or those who want to begin putting together a bond portfolio, I have compiled some thoughts and tips based on my own professional experience.

Bond investing is principally for those who have excess cash in the bank and no debt. To invest into bonds directly (i.e. not via a fund) and achieve a high degree of diversification, a lump sum investment of greater than $100,000 is required. You can start with less than $100,000, however you will be exposing yourself to some considerable risks.

It is important to also point out that the ‘guidelines’ outlined are not intended to represent financial advice in any way, shape, or form as I have not taken into account any single person's individual situation, goals, objectives, risk profile or time horizon.

Like most things in the field of finance, there are elements of art and science involved when putting together a bond portfolio. There are very few rules per se. I like to think in terms of investing via guidelines rather than having hard and fast rules in place, simply because our investment objectives and circumstances change over time and we need to be flexible in our approach.

The only real rules for investors who want to go into directly held bonds, is that they must abide by the terms and conditions of the investment statement and hold the minimum investment parcel size.

Getting started

A good starting point for putting together a bond portfolio is set out below.

-    Have a minimum of 10 bonds in the portfolio.

-    Diversify across issuers and sectors to reduce default and industry risks.

-    Diversify across maturities to reduce interest rate risk.

-    Credit ratings are a guide only – contrary to popular belief credit ratings are subjective and the agencies do make mistakes.

-    Not all issuers have a credit rating so you need to do your homework.

-    Understand the terms and conditions of the bond and what happens at maturity; whether the issuer pays back the capital, resets the bond for another term or issues equity securities.

Each of these points is discussed in more detail below.

Minimum spread and diversification

In an ideal world investors should not have more than 5% to 10% exposed to one issuer or industry sector. In some instances a 5% holding may be too high especially when the bond is categorised as junk – that is anything rated below a Standard and Poor’s (S&P) rating of BBB- or its equivalent by one of the rating agencies. See an explanation of credit ratings here.

To achieve a maximum holding size of 5% in any one issuer, industry or sector requires a diverse and liquid bond market. New Zealand’s bond market has a reasonable degree of liquidity (i.e. the ability to buy and sell on the market with relative ease). However, it is dominated by issuers from the financial services (banks) and utility (electricity and infrastructure) sectors. Therefore achieving the desired level of diversification across issuers and industries is not always feasible.

To have a maximum exposure of 5% to any one security would mean a portfolio consisting of approximately 20 securities. Finding 20 securities that are from different issuers is not hard, what creates the problem is trying to find 20 different sectors or industries.

Also to hold 20 securities would require a capital outlay of in-excess of $200,000 - assuming a minimum parcel of $10,000 per security. Add to this the additional time administering, monitoring the portfolio and filing tax returns, and it all becomes quite cumbersome.

Taking a pragmatic (commonsense) approach if an investor has at least 10 securities in their portfolio, they should be able to achieve a reasonable level of diversification across various maturities (also known as laddering).

Yes, there is an increase in the level of default risk and sector/industry risk but this is the trade-off investors may have to accept. For sums less than $100,000 it may be wise to use a professionally managed bond fund instead of doing it yourself.

Bond fund managers have access to substantially more securities than your average investor and are able to manage some of the risks more efficiently.

Default risk

Default risk is the probability the issuer will be unable to pay either the coupon (interest) on a regular basis or the principal at maturity.

Diversification across issuers, sectors and industries decreases default risk. In any investment there is an element of risk, and default risk will almost certainly exist. Even New Zealand Government Stock will have a chance of default, albeit microscopic, but nonetheless it still exists.

The New Zealand bond market is dominated by banks and utilities so achieving a broad level of diversification is easier said than done.

Reducing interest rate risk

One of the caveats of investing is to diversify in order to reduce risk. Within a bond portfolio the same principles apply.

Investors should diversify across issuers and also maturities to reduce their exposure to default of one issuer and interest rate risks. In simple terms, interest rate risk is the inability to be able to reinvest your capital at the same rate of interest you have been receiving.

This risk became evident for those investors who held  bonds with "callable" or "resetting" features which were issued in 2007 when interest rates were at their peak (circa 9%) and then subsequently fell over the next five years to below 4% per annum. These investors have seen their income levels and capital values reduce substantially. See an example of this in this story about Rabobank's $900 million 2007 resettable bond issue.

Having bonds maturing at different times of the year and over a broad period of time is also wise. Laddering the maturities of the various bonds in your portfolio helps to reduce interest rate risk – that is the risk of not being able to reinvest your principal at the same interest rate you were earning before.

Many investors will try to match the various maturities or interest payments with their need for capital.

In the context of the New Zealand market this is reasonably difficult to achieve as many bonds issued historically have maturities in either March or September each year.  This limits the ability to smooth cash flows evenly throughout the year.

For a number of investors this will not be a concern as they will have stockpiles of liquid funds from which they can call on to meet demand.

Gaining adequate diversification within the New Zealand bond market can at times be difficult as it is dominated by financial institutions and utilities. Investors should take a pragmatic and commonsense approach.

The financial institutions who issue debt securities in New Zealand are generally New Zealand or global banks and carry a credit rating of A- or above. The credit rating is important if you want a reasonably high degree of assurance you will receive your principal back at maturity.

If investors are simply chasing yield, they are in my experience, more likely to disregard credit ratings.

It is also worth keeping in mind that some issuers do not have credit ratings. Getting a credit rating is expensive and some issuers do not believe the fee is justifiable and that the assigned credit rating is actually worth anything. Infratil and Fletcher Building are two local bond issuers that don't have/get credit ratings. See Infratil's views on credit ratings in this article from Tim Brown.

Credit ratings are not a safeguard against losing your shirt

Corporate bonds can, and do, default. The probability of a bond default is generally reflected in the credit rating assigned to the bond by the rating agencies (e.g. Fitch, Moody’s or Standard & Poor’s).

Non-investment grade bonds or junk bonds have pretty high default rates historically and the further down the ratings spectrum you go the default risk grows exponentially.

This means you should at the least be wary of investing in anything rated under BBB- (or equivalent rating) by the various agencies.

Be wary of relying solely on credit ratings. As we saw through the Global Financial Crisis (GFC) bonds which were rated AAA (or equivalent) did default. Credit ratings are not infallible and we must remember at the end of the day humans are involved in coming up with the ratings and we all make mistakes. Some institutions in the U.S. are now suing Standard and Poor’s as a result of the losses suffered due to "incorrect ratings." And closer to home the AA rated Credit Sails crashed with investors losing almost all their money until a Commerce Commission settlement this week.

If you don't have the skills to accurately assess unrated bonds, or can't obtain unbiased research that you are able to rely on, we suggest you avoid investing in them.

What happens when the bond matures?

Several things can occur when a bond matures and these options will be clearly outlined in the investment statement or prospectus.

By far the most popular maturity mechanism is for the issuer to pay cash back to the investor. However if you invest into capital notes/bonds then the issuer may either: pay cash, roll over the investment or exchange the bond for equity.

Perpetual securities are just that – they do not mature. In some instances the issuer will have the ability to "call" the investment and repay the investor their capital either in full or at a predetermined percentage of the principal amount purchased or current fair market prices. Here's an example of ANZ calling a bond - and in this case issuing a new replacement one - here.

There are so many options available to bond issuers around the maturity mechanism that investors need to have their wits about them.

Know where you sit in the pecking order

Another item to be aware of is where the bond sits in the pecking order of repayment in the event the issuer goes into receivership. The list below outlines the traditional pecking order in liquidation. Obviously the higher up the food chain you are the more likely you are to get your money back in a worst case scenario.

1.    secured bonds

2.    unsecured bonds

3.    convertible bond holders

4.    preference shareholder

5.    share holders

As a gross generalisation, the more boring a bonds’ features and limits on the potential for capital appreciation, the further up the pecking order it should be and the more likelihood investors have of getting their capital back.

Where to go to source your bonds?

There are a few places you can go to source bonds for your portfolio and all of these will cost you some money in the shape of brokerage or a deduction off the yield to maturity. The amount you pay will depend on how much you are investing and the term to maturity. For an execution only facility you should expect to pay 20 to 50 basis points (0.2% to 0.5%) of the face value. Any more than this and you are being taken for a ride.

Nowadays access to bonds is via your local share broker, financial adviser or investment unit (a.k.a. Private Wealth or Private Bank division) of your local trading bank. The big trading banks all have treasury teams and deal in the secondary market for bonds. However, you may have to go through the bank’s investment adviser to get access to their pool of bonds.

If you are reluctant to deal with an intermediary to purchase the bonds on your behalf, you can pick the bonds up when they are first issued as part of the initial public offering (IPO) if there is a public pool, thereby cutting out the middle person. Nine times out of ten in a public pool situation you may not get all your application filled. Scaling back applications is common especially in those heavily over-subscribed IPOs.

Be careful of ramping up your application in the expectation you may get scaled back. I have seen this backfire on people and they get stuck with more bonds than they wanted and are forced to off-load the excess on the market and take whatever price they can.

A quick note on accrued interest

Bonds purchased on the secondary market will generally have a component of accrued interest included in the settlement value. The accrued interest is the amount of interest accrued since the last coupon (interest payment) was paid.

Keep a note of how much accrued interest is recorded on the contract notes as you should be able to offset this against interest received from the bond in the first year. The reason for this is because you have effectively bought part of the coupon payment.

Some final thoughts

When putting together a diversified bond portfolio always keep in mind that diversification across issuers, industries and maturities (sometimes this is referred to as laddering) is key. Don’t rely solely on credit ratings from the likes of S&P, Fitch or Moody’s.

The rating agencies themselves see these ratings as guidelines so you need to do your own homework. There are no real hard and fast rules outside of those mandated under the investment statement or prospectus.

In the event of there being insufficient bonds to meet your requirements, don’t be afraid to hold cash and be patient, as new issues usually come up regularly.

If you are in any doubt whatsoever please seek help from an adviser who is a suitably qualified Authorised Financial Adviser (AFA).