FIIG - The Fixed Income Experts

News and Education

Investing for yield: Part 1 - Comparing bonds and equities

by Craig Swanger | Feb 24, 2015

Australian investors have the choice of investing in many ASX listed companies as either shares or bonds. FIIG’s 2015 Smart Income Report highlighted several ASX examples, showing the historic income and capital volatility for each. This article provides some more detail on one of those examples, Sydney Airport. 

There are typically at least two ways to earn income when investing in companies: corporate bonds and shares. 

Famous investor, Warren Buffet once stated “Favour substance over form. It doesn't matter if an investment is public or private, fractional or full ownership, or in debt, preferred shares, or common equity.

The important first step is choosing companies worth investing in – that’s what Buffett means by “substance”. Then choose the “form”, that is bonds or shares that offer the best value.

For Australian investors, there are at least 30 to 40 companies for which they have this choice, including Qantas, Woolworths, Telstra, Fortescue, BHP, all the major banks plus Macquarie, BoQ, Suncorp, AXA SA, Newcrest, Cash Converters, G8 Education, 360 Capital, Sydney Airport, the list goes on. 

 Invest in substance…

Investing in these companies; applying Buffett’s advice, means investing in their substance first.  Is it a good company?  Can they grow revenues?  Do they have too much leverage?  Is the management strong?  What health is their balance sheet in? 

Then pick the “form” that offers the best value

If the answers to these questions are positive, then you look to what represents best value: the company’s bonds or their shares, remembering that risk comes from paying too much regardless of the form you buy.

The key point to understand when choosing between the corporate bond and the shares of any company is that bonds by definition are lower risk than shares; and that shares offer more upside than bonds.  However they have more price volatility than bonds

Bonds are lower risk in terms of the reliability of income because the company are legally obliged to pay bondholders 100% of what is owed on the required date, and only then can they pay dividends to shareholders. Bonds have less risk than shares again because the company is legally obliged to repay bondholders by the maturity date of the bond, before any money is paid to shareholders. 

For investors seeking regular, reliable, secure income without too much capital risk, bonds are the typical choice as they involve less capital and income risk than equities

But equities might make more sense, particularly where there is a strong likelihood of upside in the share price. 

Without a doubt, Sydney Airport has been one of the strongest performers on the ASX in recent years.  With a strong dividend and a degree of insulation against the global economic slowdown, Sydney Airport provides an example of what happens to bond and share returns when times are good for a company. Next week we will take a look at a share that has had a less impressive performance in recent years and see how the bonds performed. 

Key points regarding Sydney Airport securities:

  1. Month-to-month returns are far more volatile for shares than bonds.
  2. But over longer periods, shares return more to compensate for this risk.
  3. There is an intuitive increase in returns from the short-dated Sydney Airport bonds (2020s) to the longer-dated 2030s and then to the equities. 
  4. In fact, when we look at the “Sharpe Ratio” which is the a measure of how much return an investor has made for the risk they’ve taken, all three options have a Sharpe Ratio of 0.75-0.83 – almost identical – meaning that investors have 3 different risk/ return combinations available to them with Sydney Airport and have been fairly compensated for the risk in each case.
  5. The lower-risk 2020 bonds offered the greatest protection against an equity market downturn.

How to choose between equities and bonds when investing for yield

The benefit of being an SMSF investor is that you can in fact choose whether to use the bonds or  shares for a large number of Australian companies. The exercise required is a simple four step process[1]:

  1. What is the universe of companies that you are interesting in?
  2. What is difference between the dividend yield and the bond yield for that company?
  3. Is there enough upside potential in the share price to justify both the risk of the downside and the difference in the yield?
  4. Combine the shares and bonds in the universe of companies so as to create the best combination of reliable income and capital stability

The great advantage of the SMSF investor is that they are not constrained by asset class or other artificial boundaries. They can choose to invest in a company in a way that suits their view of that company – where they are bullish on share price growth prospects, they can invest in the equities; and where they just want income, they can invest in the bonds. 

Blending shares and bonds can create slightly higher income than a 100% bond portfolio.  This decision would be suitable where an investor believes that there is sufficient upside in some of those companies’ share prices to justify the additional capital security risk.

The reality for many investors is that they are in fact shifting from shares to bonds as they choose to invest more conservatively, for example as they head for retirement. Where an investor is already comfortable with a company and holding the equities, choosing whether to shift from that company’s equities to their bonds is a simple way to lower overall risk, increase income or both. 

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.

[1] While this approach seems at odds with the oft-followed asset allocation approach, it actually isn’t. The exercise allows investors to create a balanced investment portfolio with the desired income without taking excessive share price volatility risk. The portfolio can be balanced to achieve an overall asset allocation approach.

Copyright The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Disclaimer Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at
www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.