FIIG high yield wholesale model portfolio

Investment objective

To provide wholesale investors with a diversified portfolio of bonds that produces significantly higher returns than the RBA cash rate.

Target return

RBA cash rate plus 1.5%.

Strategy and selection process

Key requirements of each investment choice are:

a) preservation of capital,

b) reliability of cash flow, and

c) higher returns

The strategy and selection process focuses on identifying strong companies then improving returns by moving down the capital structure into subordinated debt and Tier 1 hybrid capital securities. Higher returns are also achieved by sticking to strong companies and extending the maturity.

While the investment focus looks more towards subordinated debt and Tier 1 hybrid capital, at least 40% of the portfolio must be senior debt which ranks high up in the capital structure. The majority of the senior debt is likely to be from Australian infrastructure companies that are considered to be well removed from the risks in offshore markets, particularly Europe and the USA.

A maximum of 60% of the portfolio can be from subordinated debt and Tier 1 hybrid capital securities combined (with a maximum of 50% from either category).

An allocation to international companies may also be used to improve the target return.

It is important to note that while investors are taking on greater call and credit risk by moving down the capital structure, this is only done with very strong companies that exhibit a clear credit and call history. Further, each individual issue (as opposed to issuer) must still be rated BBB or above and only those investments where the additional return for moving down the capital structure (and/or out the maturity spectrum) exceeds the risk are included.

The model portfolio has a mix of fixed, floating and inflation linked payment types, paying particular regard to the following:

a) fixed rate bonds are often best used in a counter-cyclical fashion to reduce portfolio volatility if an investor has a large allocation to equities

b) floating rate notes (FRNs) will best suit investors worried about rising interest rates because the notes pay a margin over bank bills that are reset periodically and are positively correlated to the official cash rate and inflation

c) inflation linked bonds (ILBs) will best suit investors worried about inflation because the bonds pay a margin over CPI that is periodically reset

To improve overall portfolio diversity, the process looks to select companies that the average retail investor is unlikely to have a large exposure to already as part of an existing equity or superannuation portfolio.

The pool of bond investments from which the portfolio will choose an allocation to must exceed the sub-investment grade rating by at least two notches and will subsequently be rated no lower than BBB.

All investments, individually and collectively, must pass:

a) a rigorous credit and relative value assessment by FIIG Securities’ in-house Research and Risk Teams. Detailed research reports are available on each company that is included in the final portfolio, and

b) an assessment by the Portfolio Risk Team to ensure appropriate diversification by country, industry, maturity, payment type (i.e. fixed, floating and inflation linked) and capital structure (i.e. senior debt, subordinated debt and Tier 1 hybrid capital) given the investment objective.

Portfolio parameters

Investment Universe/Authorised investments

As the portfolio is targeted to Wholesale investors, those bonds that are available to Retail and Wholesale investors in small parcel sizes of $50,000 or $100,000 are included. Further, all investments must be rated at least BBB (i.e. one notch higher than the minimum investment grade rating). Securities can be senior debt, subordinated debt or Tier 1 hybrid capital.

Minimum number of bonds

A minimum of five bonds each with face value of $100,000 or total spend of $500,000 has been chosen for the model portfolio. However, some bonds are available in $50,000 parcels and a smaller portfolio can be constructed but the result may be increased risk and lower diversity due to the greater allocation to Tier 1 hybrid securities as many are only available in $100,000 parcels. Alternately, at the expense of reduced yield a lower allocation to Tier 1 securities could be chosen. Larger portfolios can be populated with additional bonds and/or bonds that have $50,000 or $100,000 minimum face values and would be viewed as providing superior diversity.

Minimum security rating

Individual bonds must be rated BBB or above.

Minimum portfolio rating

Weighted average rating of the portfolio must be BBB+ or above.

Maximum individual issuer exposure

30%.

Maximum individual security weighting

30%.

Capital structure parameters

>= 40% exposure to senior debt

(meaning a maximum of 60% can be subordinated debt and Tier 1 hybrid debt combined).

Benchmark

RBA cash rate plus 1.5%.

Maximum maturity

Maximum weighted average maturity of 10 years (the first call date of the subordinated debt and Tier 1 hybrid securities is used to calculate the maximum weighted average maturity date).

Liquidity

All bonds must be on the FIIG Securities DirectBonds list.

This list is deemed to provide appropriate liquidity as a function of FIIG’s strong demand for bonds, in both retail and wholesale parcel sizes, all of which provides a natural exit mechanism for those wanting to sell.

Research overlay

All bonds within the authorised investment universe must pass through FIIG Securities’ research process which will include the publication of a full research report.

Value overlay

Having passed the research assessment, the individual securities also must be assessed as appropriate return for the risk i.e. demonstrating relative value.

The portfolio of collective securities will be assessed in a similar manner, having regard to diversity, industry correlation risk, maturity range and average credit rating. Diversity improvement may be chosen at the expense of lower returns for the purposes of reducing risk, including the selection of more bonds with minimum face value of $50,000 as opposed to the 5 x $100,000 used in the model portfolio.

Risk considerations

Prior to making any investment decision, it is important to understand the risks that can affect your investment. All forms of investment involve a degree of risk. While bonds are typically much lower risk than equities, investors should be aware of the risks being taken (listed below) and the return the portfolio is expected to achieve. Ultimately the investor must be comfortable that they are being rewarded appropriately for the risk undertaken:

• credit - the risk you won’t receive interest and principal when it’s due. This is an assessment of the creditworthiness of the issuer
• liquidity - the ability to sell your investment at short notice without loss of value
• inflation - the prices of goods and services accelerates and devalues the purchasing power of your capital
• interest rates - impacts the value of fixed rate bond prices which fall (rise) when interest rates rise (fall)
• credit spread – impacts the value of fixed, floating and CPI linked bonds
• call risk - that a subordinated bond or Tier 1 hybrid debt security is not called (repaid) at the first opportunity. (Note that Tier 1 hybrid capital securities also contain the potential risk of interest payment deferral or cancelation, however FIIG research selects securities for the model portfolio where this is considered remote)

market risk - unexpected conditions (i.e. economic, political) can have a negative impact on the returns of all investments within a particular market. General movements in local and international stock and credit markets,

For more information please contact your local dealer.

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