DIY capital protection portfolio construction

There are many capital protected products on the market, however most charge high fees. Why not do it yourself (DIY) using zero-coupon bonds? These bonds have the benefit of capital protection while avoiding the fees.

Many investors are amazed at how investment banks can offer you exposure to growth, while also protecting your capital; a central premise of many capital protected products. In this article, we show you how they do it; they buy a zero-coupon bond from a highly rated issuer, and invest the balance in “growth” or “volatile” assets.

A zero-coupon bond is like a very long bank bill, where the issuer agrees to pay back the principal at a future date, with no intervening coupon payments. The principal is discounted at a certain rate, in order to determine the amount paid upfront by the investor for the future cashflow. The higher the discount rate, the lower the bond price.

By following the strategy below, you can do the same as investment banks do with the capital protected products, within the asset allocation of your SMSF. Importantly if you use the capital protection strategy, as outlined herein,  you will achieve a fully protected capital position, while the typical SMSF has no such preservation plan; a good idea in the current environment.

Also, it can be shown that by investing in different maturities of zero-coupon bonds, you can free up different amounts for other growth, or volatile assets. Specifically, it can be shown that longer zeros allow large allocations to growth, or volatile assets. Crucially, that flexibility does not have to allocate all the balance to equities. Rather, a prudent allocation would be to a mixture of bonds and equities, and we would recommend more bonds than equities as you age and your investment horizon shortens.

In this article we detail:

1. The initial set-up, describing the basic structural foundation of the DIY capital guaranteed product offering.
2. Ongoing management using a 2023 Treasury Corporation of Victoria (TCV) zero-coupon bond and allocating the balance to growth or volatile assets like banks shares.
3. Ongoing management using a 2043 TCV zero-coupon bond and allocating the balance to growth or volatile assets like banks shares.

1.         Initial set-up - basic structural foundation

Following on from our definition of a zero-coupon bond above, we note that the critical factor here is the word “discount”, as the investor does not have to pay $100 to get $100 back at a future date. With the difference between $100 and the discounted price of the zero-coupon bond, the investor can allocate to other assets like volatile growth assets such as equities, and be assured that the investor receives $100 at the maturity date of the zero-coupon bond. Current pricing is as follows, although this pricing moves around with the secondary market:

• The 2023 TCV zero-coupon is roughly 4.60%, or possibly higher, which equates to a discount price of $64.49, for $100 face value due for repayment at maturity
• The TCV 2043 zero-coupon is roughly 5.10%, or possibly higher, which equates to a discount price of $22.23

Critically, the size of the discount depends on the following two factors:

1. The maturity date of the bond.
2. The rate of discounting.

The higher the interest rate, the greater the discount, and the longer the maturity, the greater the discount. As the tables show below, the current rates of discount for the TCV 2023 zero-coupon is around 4.60%, meaning that the bond value is around $64.49, leaving $35.51 to invest elsewhere. By way of contrast, the current rate on the TCV 2043 zero-coupon is 5.10%, meaning that the price is $22.23, leaving much more for investment in other assets. In other words, the longer the term to maturity of the zero coupon bond, the more that becomes available for the purchase of other assets. Also, note that as the rate of discount increases, from say 4.60% to 5.50%, the price of the bond falls, allowing investors greater scope to purchase “other” assets, like equities.

Now, if the value of the “other” investments, like equities, went to zero, and the investor had his/her entire portfolio of $100 in this DIY capital protection structure, then the value of the investment would be equal to the value that the investor placed in the zero-coupon bond; $100.

In the alternative, if the value of the investments in the “other” assets, like equities, rose steadily, then the investor, at the maturity of the zero-coupon bond would have $100, plus the value of “other” investments. In other words, if high volatility assets do poorly, then the investor has capital guaranteed by TCV and if high volatility assets do well, then the investor’s return improves over and above the base rate on the TCV investment.

Either way, the investor can only lose the $100 in the zero-coupon if Treasury Corporation of Victoria fails to pay on the maturity of the zero-coupon bond. Zero-coupon bonds, therefore, make your portfolio effectively “bomb proof”, so that it does not matter what happens to the market as the capital is protected by the underlying zero-coupon bond.

2.         Ongoing management - scenarios using the 2023 zero

Now, we consider some scenarios, so as to consider how the zero-coupon behaves in different growth scenarios and what the investor might need to do when bond yields and prices vary. In other words, this is not just a buy and hold approach, but requires ongoing care and re-balancing, so that investment objectives may be met.

Generally, the shorter the zero, the larger the bond price, and the smaller the discounting that occurs in the bond pricing, which allows for less investment in other assets. By varying the secondary market yield on the TCV zero-coupon bonds, we can generate estimates of the bond price changes, and we can also vary the secondary market price of the major bank equity, as shown below.

Table 1

Note that the current price of the 2023 is around $64.49, per $100, so that leaves the investor $35.51 to invest in growth, or volatile assets, like equities. Such an allocation would be useful for an older person, who can take less sequencing, inflation, and portfolio volatility risk; compared to the average age person. If we use an example of major bank equity, and calculate the statistics, then the major bank share is yielding around 4.51% net and 5.15% gross. When the major bank equity changes in price, we simply change the major bank share price by the scenario amount, say 10%, and we the re-calculate the yield on the same earnings. For example, if the major bank dividend pays $3.30 a year, and the share price is $76, then the net yield is roughly 4.34%, and if the share price falls 10%, the net yield becomes 4.82%, as the price is lower yet the payment is assumed constant.

Weak growth scenarios (blue box):

If we were to enter a “bust” scenario, then one would expect equities to fall in price, by around 20% and for the bond market to rally strongly; by about 1%, or 100 basis points.

In the alternative, if we were to enter a low growth scenario, then one would expect equities to fall in price, by around 10% and for the bond market to rally by about 0.5%, or 50 basis points.

Both scenarios are reflected in the blue box above in Table 1, and one can see that the bond price rises soften the equity declines, from a portfolio perspective.

Strong growth scenarios (tan box):

If we were to enter a “boom” scenario, then one would expect equities to rise in price, by around 20% and for the bond market to rise strongly in yield; by about 1%, or 100 basis points.

In the alternative, if we were to enter a high growth scenario, then one would expect equities to rise in price, by around 10% and for the bond market to rise in yield; by about 0.5%, or 50 basis points.

Both scenarios are reflected in the tan box above in Table 1, and one can see that the bond price declines soften the equity price rises, from a portfolio perspective.

Now, in each case, where bond prices change, it may be necessary to re-balance, to bring the portfolio back to the original allocation, depending on a survey of current market conditions and prospects for growth and inflation. In the lower growth scenarios, you can reduce bond holdings at a time when bond prices have risen. For example, in the “bust” scenario, the bond price rises by around 6.5%, which then becomes an excessive weight, relative to the original allocation. Here, investors can then fund extra purchases of equities at less expensive levels. By way of contrast, in the higher growth scenario, it may be necessary to sell equities, as the bond weight has fallen due to market moves.

In other words the use of this structure allows attention to be paid to changes in market conditions.

3          Ongoing management - scenarios using the 2043 zero

Generally, the longer the term to maturity of the zero-coupon bond the smaller the price of the bond, and the greater the discounting that occurs in the bond pricing, which allows for greater investment in other assets, such as equities.

Table 2

Note that the current price of the 2043 is around $22.23, per $100, so that leaves the investor $77.77 to invest in growth, or volatile, assets, like equities. Such an allocation would be useful for a younger person, who can take extra sequencing, inflation, and portfolio volatility risk, compared to an older person.

Weak growth scenarios (blue box):

If we were to enter a “bust” scenario, then one would expect equities to fall in price by around 20%, and for the bond market to rally strongly, by about 1%, or 100 basis points.

In the alternative, if we were to enter a low growth scenario, then one would expect equities to fall in price, by around 10% and for the bond market to rally by about 0.5%.

Both scenarios are reflected in the blue box above in Table 2, and one can see that the bond price rises soften the equity declines, from a portfolio perspective.

Strong growth scenarios (tan box):

If we were to enter a “boom” scenario, then one would expect equities to rise in price, by around 20% and for the bond market to rise strongly in yield; by about 1%, or 100 basis points.

In the alternative, if we were to enter a high growth scenario, then one would expect equities to rise in price, by around 10% and for the bond market to rise in yield by about 0.5%.

Both scenarios are reflected in the tan box above in Table 2, and one can see that the bond price declines soften the equity price rises, from a portfolio perspective.

Now, in each case, where bond prices change, it may be necessary to re-balance, to bring the portfolio back to the original allocation, depending on a survey of current market conditions and prospects for growth and inflation. In the lower growth scenarios, investors can reduce bond holdings at a time when bond prices have risen and equity prices have fallen. For example, in the “bust” scenario, the bond price rises by around 7.54%, which then becomes an excessive weight, relative to the original allocation. Here, one can then fund extra purchases of equities at less expensive levels. By way of contrast, in the higher growth scenario, it may be necessary to sell equities, as the bond weight has fallen due to market moves.

In other words the use of this structure allows attention to be paid to changes in market conditions.

Conclusion

In this note we reviewed the initial set-up of a DIY capital protected portfolio, as well as the ongoing management of that portfolio. In particular, we found that using two different zero-coupon bonds for two different aged investors makes perfect sense. Older investors can take less risk, as they have less time to recover from equity market volatility, while younger investors can take more risk, as they have a longer investment horizon that allows them to recover from equity volatility. However, in both cases, using either bond, capital is protected assuming the state of Victoria is able to pay debt commitments. Zeros, or zero-coupon bonds, allow the investor to weather equity volatility more effectively, as they have the interest rate duration that helps drive portfolio stability in the “tough times”. When growth falls, bond prices typically rise, and the reverse is also true.

Instead of paying a stream of fees to an investment bank for years why not “do it yourself” and use zeros to protect the capital of your portfolio? This strategy can be enhanced even further by writing options on the equity portfolio, which might best be covered elsewhere.