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Why you should diversify into corporate credit

Nicki Bourlioufas  |  25 Jul 2016Text size  Decrease  Increase  |  

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Corporate credit bond funds can provide investors' portfolios with diversity and an additional return on top of that provided by cash, though not without some additional risk.

 

For investors focused on preserving capital, corporate credit bond funds can provide an opportunity to lessen investors' exposure to equities at a time when many are heavily exposed to the share market and cash investments.

Morningstar senior research analyst Tim Wong says corporate credit bond funds can provide investors' portfolios with diversity and an additional return on top of that provided by cash, though at some additional risk.

An added bonus is that management fees are typically less than those on equities managed funds.

"Corporate credit sits somewhere between equities and government bonds in terms of risk," Wong says.

"Corporate credit sits higher up in the capital structure of companies than equity, so in the event of a default, corporate credit holders are paid out ahead of equity holders.

"That said, corporate credit does have a higher default risk then government bonds and cash, which is why it offers higher potential returns."

Credit funds covered by Morningstar typically focus on those invested in investment-grade securities, that is, bonds rated BBB or above.

Those funds are typically structured so that they aren't greatly exposed to movements in interest rates.

That means the value of the securities and the fund don't tend to move up or down with rates.

At a broader level, many of these strategies tend to reduce the underlying interest-rate risk that they carry.

They do carry corporate credit risk but the interest-rate duration tends to be very low so they are less sensitive to changes in government bond yields.

This can be achieved by favouring floating-rate bonds and/or the fund managers using derivatives to hedge out interest-rate exposure.

"That means the total return from the fund is mostly attributable to the underlying corporate bond yield and changes in credit spreads rather than to changes in risk-free interest rates," Wong says.

Wong cites three examples of credit funds highly rated by Morningstar.

They are the Macquarie Income Opportunities Fund, which Morningstar has given a Silver qualitative rating. That fund invests mostly in investment-grade debt and has a yield to maturity of about 4 per cent.

The total return over the year to 30 June was just 1.6 per cent due to widening credit spreads, particularly during the second half of 2015 and into early 2016, whereby corporate credit prices suffered relative to safer government bonds.

Another highly rated fund is the Bentham Global Income Fund [10751], which also has a Silver rating from Morningstar.

This fund offers a slightly higher yield to maturity of about 6.5 per cent as it is exposed to higher-yielding and riskier credit securities.

The fund aims to provide some potential for capital growth over the medium to long term. However, the total return over the year to 30 June was -1.5 per cent, again reflecting widening corporate credit spreads.

"This fund is a bit more prepared to take corporate credit risk when valuation opportunities are appealing and just under half of the fund's exposure is to sub-investment grade debt," Wong says.

The Schroders Credit Securities Fund [8922], rated Bronze by Morningstar, has a yield to maturity of 3.9 per cent, and like Macquarie Income Opportunities has a high exposure to investment-grade debt.

The fund seeks diversity by investing across the corporate capital structure, geographically and across the credit ratings spectrum.

The fund also has the flexibility to invest in cash and government bonds to help preserve capital during downturns in the credit cycle. The total return over the year to 30 June was 1.7 per cent.

Other opportunities open to investors include the Vanguard International Credit Securities Fund [9152], which provides investors with lower cost exposure to high-quality bonds issued globally, that is, debt predominantly rated BBB- or higher.

The total return on that fund to 30 June 2016 was 7.9 per cent, and unlike the above funds, it has a greater interest rate exposure.

As a result, the fund benefited from falling interest rates and a rise in bond values in recent times.

Wong says corporate credit can help investors to diversify out of shares and cash. Many investors, particularly self-managed superannuation funds, have well over 50 per cent of their investments in cash and Australian shares, with very little exposure to fixed-interest investments like corporate bonds.

Total SMSF assets fell to $589.9 billion during the March quarter, down from $593.1 billion in the December quarter.

SMSF share holdings dropped to $172.1 billion from $177.0 billion in the December quarter due to a share-market dip.

Despite historically low interest rates, SMSFs' cash investments rose to a fresh record of $155.5 billion in the March 2016 quarter and they now account for 26 per cent of all SMSF assets.

Australian shares account for 29 per cent. In contrast, SMSF exposure to debt securities was just $6.8 billion, or around 1 per cent of total assets, so there is ample room for portfolios to accommodate corporate credit funds.

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Nicki Bourlioufas is a Morningstar contributor.

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