Model portfolio changes to de-risk and diversify

FIIG Conservative Retail model portfolio

Readers will recall that the retail portfolio had a lower allocation than the High Yield Wholesale portfolio to financial institutions and call risk due to the conservative approach. However, given the strong recent performance and our assessment of limited upside for callable subordinated bonds issued by banks and insurers, we have made one change to further reduce financial institutions and call risk.

The other changes to the Retail portfolio actually see the issuers, Praeco and Vero Insurance, stay the same. However, to address a slight increase in risk associated with refinance regarding Praeco (see below for further details) and to comply with the selection process restrictions on minimum amount that must be in fixed rate bonds, we have simply switched from an ordinary fixed rate bond to an indexed annuity bond (IAB) for Praeco and from a floating to a fixed rate bond with the exact same maturity and call date for Vero Insurance

As such the changes to the initial portfolio first published in December 2012 are as follows:

Remove

• National Wealth Management Holdings Limited (NWHL) 2026 (callable 2016) fixed rate subordinated bond
• Praeco 2022 (callable 2020) fixed rate senior secured bond
• Vero Insurance 2025 (callable 2015) floating rate subordinated bond

Add

• Envestra Limited 2025 ILB, an Australian gas pipeline distribution company
• Praeco 2020 IAB
• Vero Insurance 2025 (callable 2015) fixed rate subordinated bond

The new retail portfolio now only has two of the six holdings in bonds issued by financial institutions. However, we are comfortable with this allocation and the relatively low risk nature of the two financial holdings that remain; Morgan Stanley 2017 senior debt, which is the only non-Australian exposure in the portfolio and Vero Insurance 2025 (callable 2015) subordinated debt, also the only callable or subordinated exposure in the portfolio.

Note that Morgan Stanley and Vero Insurance have been removed in the Wholesale portfolio below. The rationale behind this is that the initial Wholesale portfolio had a higher allocation to financial names and thus a greater percentage needed to be reduced. Further, the Wholesale portfolio is permitted to contain Tier 1 hybrid securities (which are not available to retail investors) and these Tier 1 hybrids currently provide a superior risk adjusted return and as such have been maintained (at the expense of Morgan Stanley and Vero Insurance) as the allocation to financials.

For the Retail portfolio that doesn’t have the ability to invest in Tier 1 hybrid securities, the Morgan Stanley senior debt and Vero Insurance subordinated debt are viewed as the best risk/reward options in the financial space, given the conservative parameters of the Retail portfolio. Vero Insurance has switched from floating to fixed solely to ensure compliance with the selection criteria that requires at least 25% of the portfolio be in fixed rate bonds, which would have been breached due to the removal of the Praeco fixed rate bond.

Envestra Limited is an inflation linked capital indexed bond (CIB) with a 2025 maturity date. This bond is senior secured and is also “wrapped” or credit insured by Assured Guaranty, meaning both the underlying issuer Envestra and the “wrapper” Assured Guaranty would need to default for investors to lose their capital. This CIB adds to the existing Sydney Airports 2020 CIB and new Praeco IAB to provide a greater weighting to inflation protection.

The Praeco “switch” has been undertaken to improve cashflows and address a recent increase in the refinance risk. IABs pay down both principal and interest each quarter, similar in some ways to a traditional mortgage repayment schedule. This return of both principal and interest improves cashflow of the portfolio.

Further, the refinance risk and hence credit risk of an IAB decreases over time as the principal amount is continually declining. Typically, the largest risk for an infrastructure project, and particularly public private partnerships (PPPs) such as Praeco, is refinance risk (i.e. the ability to replace the debt finance at affordable levels). In February 2013, Moody’s downgraded Praeco one notch from A1 to Baa1 (negative outlook) and suggested further falls could occur due to a perceived increase in refinance risk. Whilst we somewhat disagree with their altered philosophy, the fact does remain that a lower rating from Moody’s is self perpetuating as it will increase the cost of refinance.

To address this risk, we have “switched” from the Praeco fixed rate 28 July 2022 (callable 28 July 2020) bond which has an issue size of $215.7m and will need to be substantially refinanced between 2020 and 2022, to the Praeco IAB with a final payment of date of 15 August 2020. The Praeco IAB was issued in 2006 with an issue size of $52m but this amount declines at each quarterly repayment date and will be zero upon the last payment in August 2020.

Praeco does not have any other major debts to refinance other than the fixed rate 28 July 2022 (callable 28 July 2020) bond before the 28 July 2020 call date, at which time the IAB will have less than 3% of the initial principal remaining. However, in the event Praeco were struggling to refinance it is highly likely they would use the two year extension to 28 July 2022 that is allowed and that would more than cover the period for the last payment on the IAB of 15 August 2020.

As such the refinance risk is significantly reduced in the IAB. At the same time, the return or yield to maturity is almost the same on the two bonds (assuming an average inflation rate of 2.5%) plus the added benefit of improved cashflow for the IAB.

From a portfolio point of view, by taking on a longer maturity with the switch from NWHL to Envestra Limited and the minimal impact on return from the Praeco fixed for Praeco IAB “switch”, the expected yield to maturity of the Retail portfolio has risen to 5.52%. The weighted average rating of the portfolio has increased from BBB+ to A-.

The average term to maturity of the portfolio has increased to 6.36 years. And whilst this is considered at the longer end of our target term to maturity range, it is important note that 50% of the portfolio is now inflation linked which protects against the risk of long term inflation. A further 16% of the portfolio is in floating rate notes which are also insulated to the full effects of inflation and future interest rate movements.

The average rating and percentage of senior/senior secured debt in the portfolio has also increased reducing credit risk. 

The remaining 34% of the Retail portfolio is in two fixed rate bonds, the Vero Insurance subordinated debt with a call date of 2015 and the Dalrymple Bay Coal Terminal (DBCT) senior secured bond maturing in 2016. Both of these bonds are the shortest dated in the portfolio.

If investors are concerned with the average term to maturity, this could be reduced by substituting the ElectraNet 2015 CIB for the Envestra 2025 CIB.

The updated FIIG Conservative Retail model portfolio can be found here.

FIIG High Yield Wholesale portfolio

The original Wholesale portfolio was, by design, slightly overweight callable bonds from financial institutions as that is where much of the value was located. However, as detailed in our “de-risk and diversify” theme, this sector has performed strongly and we believe it is now time to take some risk off the table. Accordingly, the revised portfolio has made the following changes:

Remove

• AXA SA perpetual (callable 2016) Tier 1 hybrid. We have removed this from the portfolio due both to its very strong recent performance and the rating downgrade that occurred in December last year placing it at BBB- and on the cusp of the allowed minimum rating under the portfolio parameters. It also reduces the exposure of the portfolio to international or more particularly European risk
• Vero Insurance 2026 (callable 2016) subordinated debt has performed well and has been removed due to our assessment of minimal upside from where it is currently trading
• Morgan Stanley 2018 senior debt has been removed to reduce international risk of the portfolio
• Praeco 2022 (callable 2020) fixed rate senior secured bond

The first three are issued by financial institutions, with AXA SA and Vero containing call risk. As detailed above, the Praeco fixed rate bond has been “switched” for the Praeco IAB to address the recent refinance risk issues raised and hence self perpetuated by Moodys.

Add

• Envestra Limited 2025 CIB is the same one as included in the conservative retail portfolio and detailed above
• Dampier to Bunbury Natural Gas Pipeline (DBNGP) 2019 fixed rate senior secured bond is a local monopoly gas pipeline network based in WA and adds both to the domestic nature and solid returns of the portfolio
• JEM NSW Schools II 2031 is an inflation linked indexed annuity bond (IAB). This senior secured ranking IAB pays down interest and principal over the life of the bond and provides valuable cash flow to the overall portfolio, as well as increased inflation protection
• Praeco 2020 IAB

The four replacements are all senior secured ranking domestic infrastructure securities, three of which are inflation linked.

Swiss Re and National Capital Instrument Tier 1 hybrids remain in the portfolio as they continue to exhibit value and are considered to have lower call risks. There is now no subordinated debt in the Wholesale portfolio. As such the new portfolio has a very high 74% weighting to senior ranking debt and only 26% to Tier 1 hybrid securities.

As with the Retail portfolio, by taking on longer maturities, the switch from callable financial bonds into senior ranking infrastructure has increased the expected yield to maturity of the portfolio to 6.13%. Having said that, the removed AXA SA Tier 1 is a perpetual security and the Vero Insurance subordinated bond has a legal maturity of 2026 in the event they are not called.

The updated portfolio contains significantly less exposure to international markets and has less subordination and call risk. The weighted average rating has also increased from BBB+ to A-. However, it is fair to say the new Wholesale portfolio has a positive weighting to the domestic economy and the infrastructure sector in particular. We consider the risks in these sectors very manageable and the bonds chosen continue to exhibit value, particularly on a yield to maturity basis.

Finally, the new portfolio has increased its allocation to inflation protection to around 49% and includes the Praeco and JEM NSW Schools IABs for improved cash flow. The inclusion of longer dated inflation linked bonds has seen the weighted average maturity extend to 9.89 years, however, as discussed above the high allocation to senior/senior secured inflation linked and floating rate notes reduces the risks associated with longer maturities, as does the principal pay down mechanism of the two IABs in the portfolio which reduces refinance related credit risk.

The updated FIIG High Yield Wholesale model portfolio can be found here.

Please note, you may be asked to login to view our Wholesale portfolio. If you do not have a FIIG ID and password or have misplaced your details, please contact your FIIG Representative on 1800 01 01 81. 

FIIG model portfolio strategy and selection processes

Click here to view Conservative Retail strategy and selection process.

Click here to view High Yield Wholesale strategy and selection process.

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

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