October 3, 2007

• The yield of the investment
• The credit rating of the investment
• The issuer of the investment
• The maturity date of the investment
• The coupon (interest) payments from the investment

The Australian Stock Exchange categorises the fixed interest investments listed on their exchange in three categories:

• Corporate Bonds
• Floating Rate Notes
• Hybrid Securities (Convertible Notes and Convertible Preference Shares)

We will discuss these separately, one at a time. As well as the ASX website, I have also used data from the Weekend Australian Financial Review, which publishes a table of Interest Rate Securities and is a reasonable source of information for people considering investments in this sector of the market.

Corporate Bonds

The corporate bonds listed on the ASX have exactly the same characteristics as regular bonds. Basically, you get a known series of interest (or coupon) payments on a regular basis and the face value of the bond paid back at the end of the term - provided that there is no default by the bond issuer.

Let's look at a specific example, from the table in the Weekend Australian Financial Review.

ALE property group has a corporate bond listed on the ASX (code LEPHB). It has a face value of $100 and will mature in the year 2011. The bond pays semi-annual interest at a rate of 7.265%. It last traded at $102.01.

Interestingly, at maturity it has a conversion value of $102.50. This is a little different from the usual bond where the face value is the amount of the final payment, plus the accrued interest.

The ASX has a list of the credit ratings of various fixed interest securities - these are now somewhat out of date so don't rely on them for making investment decisions; however we will use them for the examples that we look at in this chapter. The ASX website has a reference to the Standard & Poor's website (www.researchchoice.com) for more up-to-date credit rating information.

The ALE bond had a credit rating (at the time of the last ASX update) of BBB. This is the lowest "investment grade" rating for a bond.

Overall, the ALE bond looks like a reasonable option within a diversified fixed interest portion of a portfolio; it pays reasonable income twice a year, is trading at about the same price as its final conversion and has an investment grade rating from Standard & Poor's.

Quite a number of the listed fixed interest securities don't have a credit rating, so how should these be handled in a portfolio? The benefit of a credit rating is that an agency such as Standard & Poor's have done a thorough assessment of the fixed interest issue with regard to the ability of that issue to make all the promised payments to the investment holders. In the absence of such a rating I think that it is impossible for an individual to do a similar assessment, and therefore I would tend to either avoid unrated securities, or at the very least consign them to the higher risk investments in the portfolio. I would not have unrated securities in the low-risk, fixed-interest portion of an investment portfolio.

Floating rate notes

Floating rate notes are slightly different from straight bonds, in that they pay an interest rate that can vary if interest rates change. I think that this is a particularly attractive feature because it means investors will always receive a fair rate of income return for their investment regardless of interest rate changes. It also means that all else being equal, there will be less fluctuation in the value of the note when interest rates change, as compared to a corporate bond.

This makes floating rate notes worthwhile investments: there is less capital volatility with regard to changes in interest rates and, regardless of how interest rates change, you will receive income relative to the current interest rate in the economy.

One characteristic of these notes is that quite often there is no set maturity date, therefore investors should be cautious that they don't pay too much above the face value of a floating rate note only to have it redeemed soon after purchase for its face value.

Even though there is no maturity date, keep in mind that if you invest in a floating rate note and want to get your money back, you can always sell it on the ASX - although the price is more variable than an obligation to pay back the face value of a bond.

Let us look at an example. Woolworths has a floating rate note with the ASX code WOWHB. It is currently paying quarterly interest of 7.51%. This interest is worked out as a 1.1% premium to the three-month bank bill rate. It is interesting to see how this changes over time. The interest payment in June 2006 was 7.005%. After interest rate rises in the economy, the interest payment in June 2007 was 7.51%. As you can see, Woolworths note holders have received the benefits of the income rate rises.

These securities were issued in 2006, and had a BBB rating - which is at the bottom end of the investment grade spectrum - at the time of being issued.

In August 2007 good quality cash accounts were paying 6-6.5%, so a 7.5% interest return is a premium to this - as compensation for the risk of investing at the lower end of the investment grade credit rating spectrum.

The current price of a WOWHB income security is $101.70, with a face value of $100.

This is an investment grade, fixed-interest offering paying a reasonable interest return, and is well worth considering for the fixed interest component of a portfolio.

Hybrid securities: convertible notes and convertible preference shares

Hybrid securities have characteristics of both debt and equity (share ownership). Usually that means that they pay a known income stream up to a certain date, and then at that date convert into a number of shares of the hybrid security issuer.

The ASX splits hybrid securities into two markets:

• The convertible note
• The convertible preference share

The convertible note converts into a preset number of shares at conversion; for example, each convertible note might convert into one company share at the point of conversion. These notes will be quite volatile in price, because the price of the underlying company share is the effectively the end payment of the bond.

The ASX website has this example on its website of a Bendigo Bank note (BENGA) that converted into one Bendigo Bank share (BEN) at the redemption date. As you can see, the price movements mirrored each other.

My feeling in this case is that if you really wanted to invest in Bendigo Bank shares, you may as well buy them directly.

The convertible preference share has a set dollar value on conversion, at which time a number of shares in the issuing company are purchased, often at some sort of a discount.

This means that it is not nearly as volatile, because at the end of the term the conversion is based on a set dollar amount. For example, at the end of the term the conversion may be the purchase of $100 worth of shares in the issuing company.

A lot or the hybrid securities are also "resettable". This means at conversion people have the choice to either convert into ordinary shares of the company, or to roll over into another fixed interest term.

In general, the combination of equity (shareholder) and debt characteristics is not something I am overly enthusiastic about. If you want equity (share) style risk and return, then I think you should buy shares. If you want the reliable income and low volatility of bonds, then you buy traditional bond-style investments. I don't see a great advantage to investors in combining the two into one investment when they can already be combined in the one portfolio.

Diversification, diversification, diversification

One of the important aspects of investing in good quality fixed interest securities is that diversification is crucial to a successful investment experience. There is a risk that by simply investing in a few fixed interest investments you could be under-diversified - and therefore taking on needless investment risk.

With fixed interest investments, the bottom line is that all securities with similar credit ratings (and therefore assessed levels of risk) will offer a similar investment return. You won't get a better return by especially investing in one over the other. However, you could damage your returns if any one of the investments you select has a default. If you only invest in one security, the damage could be significant; if you invest in a broad range the damage caused by any one default is minimised.

With share investments there are people who say that if you have the skill to select companies that are going to outperform in the future you may hurt your overall investment returns by being well diversified. This argument does not hold true for general investors in fixed interest securities Their return is limited by the interest payments and final payment at maturity, so diversification does not limit return at all - it just reduces the damage of a default on your overall portfolio.

Conclusion

Listed interest rate securities with investment grade credit ratings, held in a diversified portfolio, are a low cost and liquid way to get fixed income exposure for an investment portfolio.