December 29, 2007

Value Idea: Fixed Income

I think fixed income investing does not get its fair share in the individual portfolio level. I think it is a big mistake. Fixed income can enhance a portfolios returns and reduce risk. Fixed income market dwarfs the stock market in size and volume of transactions. Individual investors also see bonds as one category however the truth is farm from it. Bonds have many categories with different risk/ reward profiles and picking among them is as important as picking solid businesses.

I am always aiming to keep at least 20% of my portfolio in fixed income and again picking which debt to include is a matter of perceived value. Debt can be over or under valued similar to a stock, so you have to be a picker of the ones that represent a margin of safety and large upside value. In this post I am thinking of some ideas about different fixed income categories that can enhance my returns going forward and possibly give you some ideas to research further.

Inflation indexed Bonds

Real Return Bonds in Canada or TIPs / Inflation protected bonds in the US can return a great value going forward. These bonds are government issued so there is no additional credit risk to treasuries. These bonds pay you a rate of return that is adjusted for inflation. Unlike regular (nominal) bonds, this feature assures that your purchasing power is maintained regardless of the future rate of inflation. RRBs pay interest semi-annually based on an inflation-adjusted principal, and at maturity they repay the principal in inflation-adjusted dollars. For more information on Canadian real return bonds you can view here.

An investment in TIPs is call that inflation going to increase going forward. There is a strong case for inflation to increase, which I am not going to discus here, so if you are not worried about inflation obviously forget this category as a potential investment.

Emerging Market Debt (EM)

Emerging market debt is more attractive to me than their equities due to recent run up. Emerging Market governments are awash in cash due to solid economic performance that is expected to continue forward. Refinancing risk is low as sovereign wealth funds are ready to invest significant amount of money in emerging market debt, which is no longer dependent on North American and European investors. More importantly these bonds have come down in price due to the credit crises with no change to the risk profile in my opinion.

And the way I choose to monetize this idea is through closed end bond funds rather than individual bonds for two reasons:

  1. Closed end funds are selling at large discounts currently and those discounts widened significantly over the summer.
  2. Closed end funds offer a diversification form issuer's risk.

I have went through several Emerging Market closed end funds and found the following to have the most liquidity and best operating history compared to others.

Alliance BernsteinAberdeen Asset ManaFranklin Templeton
TickerAWFFAX GIM
As of12/28/200712/28/200712/28/2007
Closing Share Price$12.54$5.82$8.42
Closing NAV$14.22$6.62$8.83
Premium/Discount-11.81%-12.08%-4.64%
Average Premium/ Discount (1 yr)- 8.18%- 5.98%+ 3.65%
Current Yield7.76%7.07%5.37%

Banks and Corporate Debt

US/ Canadian bank bond debt, in particular, have gone down in value due to the credit crises, however some institutions have solid financial positions that will enable them to meet their obligations going forward.

Corporate bonds are cheap and a better investment than many stocks or government debt currently. Investors in investment grade corporate debt are demanding 180 basis points extra interest compared with similar-maturity government notes, up from 99 basis points in July. The investment grade bonds are good as treasuries as their credit quality profile has not changed significantly and will reprice higher once this crises behind us. The spreads have already began to reprice as evident from table blow.

Current YieldYesterdayLast WeekLast Month
spread 10yr AAA0.961.041.131.07
5 yr AAA1.111.111.121.13
2 yr AAA1.191.141.281.17

Municipal Bonds

Although US Municipal bonds offer higher yield now, I would not touch them. Several analysts and managers have been recommending munis due to their higher comparativeve yields. See graph below to see the shift in munis yield over their yields earlier this year. A typical triple-A rated 10-year muni bond is yielding 3.9%, while comparable 10-year Treasuries are yielding 4.2%. That means an investor in the 33% federal tax bracket would have to earn more than 5.8% in a taxable bond to beat the muni. On 30-year bonds, the muni and Treasury yields are virtually the same—4.7% and 4.6%. To beat the 4.7% muni, an investor would have to get more than 7% in a taxable bond. However the risk of owning munis have gone p and I do not care what rating they hold, as we all know rating means nothing as evident of all AAA rate subprime debt out there:

  1. high housing foreclosures will stress municipals cash flows as they collect less taxes from empty houses.
  2. credit risk insurance is not so dependable as MBIA and other insurers have trouble raising capital, their ability to honour their agreements to insure munis against default is suspect.
  3. Some concerns about their investment funds holdings as some may have subprime debt as was the case in Florida.

As a Canadian investor these do not make sense at all as you get taxed on the income.

Government Debt

US, in particular, and Canadian, to a lesser extent, Government bonds are overvalued because investors have flocked to them as safe heaven and bid up their prices due to the credit crises. As you can see from the graph the yield curve have shifted downwards on all points since the beginning of August. And if you factor inflation running at 4% according to latest figures, you are really losing on most points except the 30 yr maturity where you will be earning a solid return of .5%, lucky you!!

When the crises subsides look for these to come down in price as investor switch to equities dumping loads of treasuries and bonds. Although they are safe but their risk/ reward profile is not enticing.

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Sources: Yahoo Finance, BusinessWeek, Bloomberg, Bondsonline.com

6 comments:

John said...

Great post

I had never considered the emerging market debt play

I do the same Nav vs. actual price arbitrage in the closed end trust market. Check out CTD.un for some big returns.

Sami said...

thanks John.

Ctd.un looks interesting.

Anonymous said...

nice post.

augustabound said...

Like John, I've never considered EM debt but I find it interesting. Where do you find listings for them, same as the North American fixed income?

Sami said...

augustabound,

The fund listed in the article are listed on NYSE. there is even a new ETF for emerging debt but it is on the smallish side and illiquid. The closed end funds here make much better alternative than the ETF.

augustabound said...

LOL, hence the ticker symbols, my bad. I didn't see them there.