Investing for yield: Part 1 - Comparing bonds and equities

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.

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