New Investment: Bendigo Bank Hybrid

Following on from yesterday's post, I did some research on Australian Bank Hybrids. Essentially, a hybrid is a convertible bond. At a certain date it may be converted into shares of the issuer. The ratio is not set up front but is based on the share price at the conversion. In the meantime, you are paid a floating interest rate that is a fixed margin above the market interest rate. As a result, there is little price risk if everything goes well. However, if the issuer gets into financial trouble the value of the bonds can be reduced or in theory go to zero, like any other corporate bond.

I thought about an offering from Judo Bank. The bank is new but is making money and its credit rating was recently upgraded, but Interactive Brokers didn't list it. The next best yield-wise and with a better credit rating was from Bendigo Bank. So I bought 350 shares of BENPI.AX.

Investments Review: Part 7, Bonds

MCP Income Opportunities Fund (MOT.AX). Share of net worth: 1.75%. IRR: 14.8%. This fund invests in Australian private credit. It yields around 7% per annum. It performed better than other similar listed funds during the COVID crash. We use this to park cash that we don't need immediately as it pays more than our margin loans cost.

Ford. Share of net worth: 1.46%. IRR: 2.1%. We own two Ford bond issues that mature later this year. This is the tail end of the bond investments we made with the inherited money while we decided how to deploy it.

Ready Capital (RCB). Share of net worth: 0.77%. IRR: 5.3%. This is a so-called baby bond. These trade on US stock exchanges and usually have an issue and redemption price of $25. The distributions are considered to be interest but they have none of the other peculiarities of actual bond issues. They usually have high yields. This issue matures in July 2022 and has a "coupon" of 6.2%.

Asset Allocation at "Peak Bonds"

At this point we have probably finished expanding our allocation to bonds and from here the share will fall again. So, I thought it would be interesting to post a snapshot of our asset allocation here to contrast with in later posts. All the blue segments in this pie chart are equity related including the allocations to private equity and hedge funds, though only the first four are allocated to listed long-only stocks. For the first time I have split the commodities category into actual gold and futures which includes managed futures and the cash used in our own trading. Cash is money in our regular bank accounts.

We don't include our house in the breakdown and there are also debts, particularly a margin loan and our mortgage. This is just the assets side of the picture.

New Investment: Santander UK

Bought my first US corporate bond - a Santander UK bond maturing on 14 March. This supposedly gives a yield per annum of about 2.85%, which is more than treasuries of the same maturity. The original coupon on the bond is 4.2575%, so it is trading at a price of above 100. It pays quarterly interest. Fees for trading corporate bonds are higher than for treasury bonds at Interactive Brokers, but I still figured it was worth it.

Santander UK is the result of the merger of three former UK "building societies" - a bit like credit unions. It is owned by Spain's Banco Santander group but is managed separately. The maturity date is before the scheduled Brexit date on 29 March, so I figure Brexit shouldn't affect getting paid when the bond matures. The bonds are denominated in US Dollars not Sterling.

New Investment: U.S. Treasury Bills

Interactive Brokers currently pays 1.7% interest on U.S. Dollars. But U.S. government bonds pay more than that and are supposedly risk free, so I thought I would give it a try. I am concerned that U.S. interest rates could still rise and so I don't want longer term bonds. So, I just bought a U.S. Treasury Bill expiring on 12 February. My idea is when that matures, I'll put part of the proceeds towards buying Australian Dollars. I plan to build a ladder of these and so force myself to buy Australian Dollars slowly.

At IB the commission for buying bonds is $5 and it turns out that the minimum trade size for treasuries is $100k. This isn't stated anywhere, but when I tried buying $50k last week, I got a message that my trade size was too small, whereas this trade went through. I'm gradually moving U.S. Dollars to my IB account - I can move up to $100k every 7 business days using the ACH method.

I've thought about municipal and corporate bonds too, but these can be illiquid. For example, for the nearest term Berkshire Hathaway bond, only $1000 is currently being offered.

New Investment: PERLS XI

As a place to park Australian Dollars cash until I can move it out of Interactive Brokers, I bought some PERLS XI hybrid bank securities. These are Commonwealth Bank bonds that instead of paying interest pay franked dividends. The "grossed up" rate is 5.7% p.a. roughly. At some point the bonds should convert into Commonwealth Bank shares. However, the conversion rate isn't pre-determined. Instead, $100 of bonds will convert to $100 of shares at whatever the share price is at that time. I thought this was better than earning only 1.4% interest on my money, though there is a risk that the capital value will fall if interest rates rise in Australia. That doesn't look very likely at the moment to me. They are in theory less safe than bank deposits, but the risk of Commonwealth Bank getting into bad enough financial trouble in the next few months to reduce the value seems extremely low to me.

I think this is the first time I have ever bought bonds directly for my own account.

UBS are Recommending 34% Allocation to US Fixed Income - Really?

UBS recommending 34% allocation to US fixed income. I guess this might makes sense if they mean treasury bills (90 day maturity). Don't pay any interest (but not negative like some places in Europe) but US Dollar might still appreciate. Longer term US bonds seem risky if interest rates will eventually go up. I wouldn't rule out though us being in a new long-term zero risk free rate equilibrium. I suppose that this allocation was intended for US clients?

My Mom's money managed now fully by UBS (but she is near their minimum entry level net worth, not what they think of as wealthy) is mostly in fixed income now due to the court order we got. Actually, it looks like that there are no US government bonds or corporate bonds in her account at all, though they are all US Dollar bonds. Things like World Bank, Province of Ontario, EBRD, African Development Bank, Statoil, Shell, Swedish Export Credit Corp etc.

Buffett Advises Against Long-Term US Bonds

Buffett speaking in India

In a recent post I referenced the Credit Suisse report that argues quite reasonably that long-term bonds are unlikely to be a good investment going forward. Of course, if you believe in efficient markets the prices of long-term bonds should already reflect that interest rates will rise in the future and, therefore, buying long-term bonds now should still be an OK investment. US short-term government bond interest rates remain near zero, but interest rates on 30 year bonds have risen significantly since the depths of the financial crisis:



History suggests though that the adjustment is insufficient. The Credit Suisse Report shows that there are long periods where bonds do not beat inflation in most countries with the partial exception of Switzerland. Now Warren Buffett warns against owning long-term US government bonds. His concern is both that inflation will reduce the real value of the bonds and that the dollar will fall in value against other currencies due to inflation in the US. It's hard to imagine the US Dollar falling in value a lot against the Euro, Pound, or Australian Dollar given how cheap things are in America but against developing country currencies such as the RMB that is possible.

My mother has a short-term USD bond fund and a longer-term Sterling related bond fund. We do want to reduce both of these and especially the latter. Snork Maiden and I have a variety of exposures to bonds though the total is only a small apart of our portfolio. The exposure is only 5.7% of net worth in total. The most significant types of bonds are Australian fixed interest and US corporate and mortgage related bonds. The latter are the main holdings of the CREF bond market fund, which did surprisingly well through the financial crisis (we should have had more of it):



This small level of exposure should be safe I think and I don't intend to lower it.

Janus US Short-Term Bond Fund

This is the other bond fund in my Mom's portfolio. It has done very well in recent years, though it didn't do much just after we bought it in 2003. I am trying to get access to Janus World's website to get more info - they haven't yet sent me a password but I managed to get the charts above from UBS's website. If it is similar to the short-term bond fund marketed in the US then it is heavy in US government issues which explains its strong performance recently. I'm thinking of selling half and putting it in Man-AHL Diversified, a managed futures fund that we only have a small allocation to at the moment (2.2%). Such a move move would take the allocation to Man AHL up to 7.5% and to the Janus bond fund down to 5.3%. The overall bond allocation would go down to 23% from 27% and the alternatives allocation up from 19% to 24%. Maybe I'd leave a bit in cash...

The rationale is that US interest rates are very low and many people are talking about a US bond bubble. On the other hand I think we should retain some exposure to US bonds and this fund seems pretty good. On the other hand, it is a short-term bond fund and so should be relatively little impacted by a rise in interest rates. And would be impacted in a good way if new bonds they buy have higher yields in the future?

Invesco Sterling Bond Fund

This is my Mom's largest single investment at 12.6% of the portfolio. It wasn't planned this way. I instructed Citibank to buy a given amount of this fund in US Dollars. They bought the same number in Sterling. Soon after that we ditched Citibank. The fund had been doing great when we bought it in November 2005:



But this year it severely underperformed its index. On top of that Sterling has declined against the USD so we lost more in USD terms but that's an unfair comparison as this money was likely to be kept in Sterling or Euro investments in any case. The reason for this year's poor performance is of course the corporate bond market which is 80% of the fund:



So, I guess we'll hold on and wait for corporate bonds to recover?

Duration and Stock-Bond Allocation

Interesting discussion from John Hussman about changes in "duration" and the optimal allocation between stocks and bonds in a portfolio. Duration for bonds is the sensitivity of the bond price to a change in interest rates. Bonds with distant maturities are much more sensitive than short-term bonds and therefore more volatile. Hussman also talks about a duration for stocks which is the sensitivity of stock prices to changes in the discount rate applied by investors to company's cash flows. He argues that this is equal to the reciprocal of the dividend yield.

Anyway, the lower the duration of an asset the more an investor with a given time horizon can allocate to it. Given the increase in stock yields and the fall in US Treasury yields recently investors should allocate more to stocks and less to treasuries. This is an alternative argument for valuation based market timing.

BTW I checked the CREF Bond Market Fund's holdings and less than 10% is in long-term treasuries. So there is no reason to dump that fund based on the high prices of long-term U.S. bonds.

Bill Gross' Latest Commentary

More evidence that in Gross' opinion the recent bear market in bonds is over.

More Bond Bulls

These guys' Q1 report - highlighted in John Mauldin's latest letter - has an identical viewpoint to my own on inflation, bonds etc.

Turning Point in the Bond Market?

Great article from Bill Gross explaining why the bear market in bonds (equals rising long term bond rates) should be almost over. It's a bet I have been making through holdings in bond and majority bond mutual funds, so far with neither good or bad results (apart from missing out on stock market gains I could have made. Colonial First State's Conservative Fund has however performed nicely over this period.

Today the gold price touched $600 per ounce in the futures market and a little less in the spot market. The Australian Dollar has been rally ever since I did that transfer to Australia - so good timing for once. On the other hand the stock market has been resilient but the McClellan Oscillator has been pretty weak the last three days.