The age-old investing wisdom was always to maintain a portfolio consisting of 60% equities and 40% bonds (commonly referred to as the “60/40 portfolio”). Bonds have been out of favour since the Global Financial Crisis though, as TINA (“there is no alternative”) took over and investors piled into more risky assets.
The main reason for this was the incredibly high prices, or inversely, the incredibly low yields that bonds offered investors for most of the past 15 years. (The price and yield of a bond are inversely related. For example, when the yield of a bond increases from 1% to 2%, the price of that bond falls). In fact, bond prices (yields) had steadily increased (declined) for about 30 years up until 2020.
Notorious Bonds and the Tale of Silicon Valley Bank
This has been a hot topic of late given the collapse of several U.S. banks, including the high profile failure of Silicon Valley Bank (SIVB). SIVB had a large portion of its balance sheet invested in long-term bonds, predominantly mortgage-backed securities with a 10-year duration. Without getting too much into the weeds, the main issue here was that these bonds were purchased during the pandemic at extremely high prices (with yields of 1.70% to 1.80%, for example). During this time, central banks such as the U.S. Federal Reserve and the Reserve Bank of Australia had cut benchmark interest rates and implemented other measures such as quantitative easing to lower interest rates, stimulate the economy, and reduce the risk of deflation. This was quite effective, and the yields on fixed income securities fell sharply. With a huge influx of deposits from a boom in technology, venture capital and special purpose acquisition companies (SPACs), along with very little loan demand, SIVB’s management felt that they had very little option but to invest in these otherwise “safe” (but expensive) securities.
Fast forward to 2022 and the economic environment is vastly different: restrictions on movement have eased, the economy has roared back to life and central banks now have to combat the challenges of low unemployment and higher levels of inflation. As a result, they rapidly increased interest rates – at the fastest rate on record. Higher market interest rates cause these bonds offering low yields to significantly decline in value. Simultaneously, SIVB’s deposits begin to decline as the bank’s clients fall on harder economic times and have a greater need to use their funds. Eventually, SIVB needed to sell a portion of its bond portfolio, which at today’s interest rates, were worth substantially less than when the bank purchased them.
Are Bonds Lower Risk?
Putting the extreme example above to one side for a moment, bonds are widely regarded as being a less risky asset class than shares. There are two main reasons for this. Firstly, bondholders are legally entitled to receive a regular fixed payment (with the exception of zero-coupon bonds, which are discussed more below). This differs from a dividend for shareholders, which is optional and can be modified or eliminated at the discretion of the Board of Directors (although they generally try to avoid this circumstance). Secondly, in the event of bankruptcy, bondholders are entitled to receive proceeds from the remaining funds before shareholders – who are typically last in the capital structure. (While this is not always the case and we did see a special situation this week with holders of Credit Suisse’s additional tier 1 or “AT1” securities wiped out while equity holders stayed afloat in the takeover by UBS, it is generally true. It certainly pays to read through the details contained in a prospectus, even though they can sometimes be more than 600 pages long!).
How Do I Make Money from a Bond?
The bond market is enormous (much bigger than the equity market) and there is huge variety in the types of fixed income securities available: hybrids, convertibles, some with warrants attached, et cetera. However, sticking with some of the more basic vanilla bonds for now, there are a few main types.
Zero Coupon Bonds: the bond is issued at a discount to par (e.g., 97%) and the investor receives the full amount at the maturity date (e.g., 100%).
Fixed rate securities: similar to a term deposit from a bank, these pay interest in the form of coupons on a regular basis and the principal (initial capital investment) is returned to the investor at the maturity date;
Floating rate securities or floating rate notes (FRNs): pay interest based on a benchmark rate that changes over time. This benchmark is often the Bank Bill Swap Rate (BBSW), which is basically the rate at which banks borrow from each other for different periods of time. The spread (or the margin over the benchmark) is set at the beginning. As with fixed rate securities, the principal is returned to the investor at the maturity date.
Index-linked securities: similar to FRNs, these pay a variable interest rate based on an inflation index such as the Consumer Price Index (CPI). They can be capital-indexed bonds (where the initial capital investment is increased according to the index) or index annuity bonds (which are similar to mortgages, where the investor receives regular payments that include both principal and interest).
In addition to receiving the coupon payments and/or higher capital amount at maturity, investors can also profit if market interest rates decline. Lower interest rates increase the value of certain bonds (such as fixed rate and zero-coupon securities), and instead of holding the bond to maturity, an investor may be able to sell the bond in the secondary market for a profit.
Who Issues Bonds?
Both governments and large corporations issue bonds, while smaller companies (like consumers) typically do most of their borrowing from banks. Governments such as Australia (who maintain their own currency and borrow in that currency) are largely considered ‘risk-free’ because they can always increase taxes to pay off any debts. The U.S. government is the largest issuer globally, and investors can buy securities ranging from 1 month through to 30 years (collectively referred to as the ‘yield curve’). There is also a larger market for corporate bonds in the U.S., while in Australia it is mostly limited to the ASX 50, including companies like the big four banks and the largest mining and infrastructure stocks. The interest rates that these companies pay are based on their perceived risk, which commonly involves a premium or margin over the government bond rate (referred to as a ‘credit spread’).
Alphabet Soup – Is Your Bond Investment Grade?
Fixed income securities are given a grading by credit rating agencies Standard & Poor’s (S&P), Moody’s and the lesser-known Fitch. S&P/Moody’s copped a lot of flak for their performance during the GFC, however, one clear trend from their track records is that companies that are given a grading of “investment grade” (BBB- for S&P/Fitch, Baa3 for Moody’s) are much less likely to default (meaning investors don’t receive all of their interest or principal payments). As a result, companies that do not receive an investment grade rating pay much higher interest rates. The securities issued by these companies are often called ‘high yield’ or ‘junk’ bonds, and have become increasingly popular from both companies and investors, including billionaire Howard Marks. While some sub-investment grade companies are high-quality (often emerging) businesses, caveat emptor.
No Time Like the Present?
The rapid rise in interest rates over the past year has finally provided investors with more attractive yields on fixed income securities. While the world of bonds might seem complex at first (and there is a huge variety of options, some with very detailed provisions), now might be the time to introduce yourself to the more ‘plain vanilla’ types and consider adding a portion to your portfolio. As investors, management and stakeholders in Silicon Valley Bank can attest, it’s important though to consider the price (yield) on offer, and importantly, how that compares to inflation.
One of the advantages of investing in smaller companies is that their share prices typically move less in line with the overall share market (i.e. they are less correlated). Instead, their performance is more driven by the individual company’s operations. Smaller companies also often have bigger share price movements when they report their earnings results, which for most companies in Australia, happens in February and August. Two such companies that had strong (negative) share price reactions in their previous earnings reports in August 2022, but have since generated solid results and may be on the verge of a rebound, are Aussie Broadband and DGL Group.
Aussie Broadband Ltd (ASX: ABB)
The Business:
Founded in 2008 from the merger of two smaller regional providers, Aussie Broadband (ASX: ABB) is now Australia’s fifth-largest Internet retail service provider (behind Telstra, TPG, Optus and Vocus). Its main product is a connection to Australia’s National Broadband Network (NBN) for speeds ranging between 12 megabytes per second through to 1 Gigabyte per second, along with mobile phone plans, Voice over Internet Protocol (VoIP) and Fetch TV subscriptions. Aussie also acquired Brisbane-based telecommunications and IT solutions provider Over the Wire in 2022 to strengthen the Company’s position with business and enterprise customers
What happened in 1H FY23?
Revenue up 27% year-over-year (YoY) to $379 million
Operating earnings (EBITDA) up 86% YoY to $41.1 million
Gross margin increased 250 bps YoY to 34.9%
Total broadband connections up 27% YoY to 635.2k
Residential +17% to 495k
Business +24% to 47.3k
Enterprise & Government +10% to 7.26k
Wholesale +147% to 85.7k)
Operating cash flow up 35% to $30.8 million (74.9% conversion of EBITDA)
Aussie has continued to increase its share of the NBN market, reaching 7.01%, up from 5.66% in the prior year (and 3.51% in June 2020 and 1.09% at June 2017). This is based on its well-known high levels of customer service, which again had it awarded ‘Most Trusted Brand in Telecommunications’ at the Roy Morgan Trusted Brand Awards (for the third year in a row). Aussie has also seen growth by branching out into wholesale (or ‘white label’) deals, including with Origin Energy, and with business and enterprise customers through the acquisition of Over the Wire and the buildout of its own direct fibre network.
Aussie’s fibre project was completed in the second half of 2022, delivering more than 1,200 kms of backhaul fibre that are expected to generate annual savings of around $13.5 million as 121 “Point of Interconnects” are transferred from agreements with Telstra to Aussie’s own network. This was part of the reason why the Company’s EBITDA grew much faster than revenue (along with some higher margin sales). Higher EBITDA was also the result of synergies from the Over the Wire integration, where Aussie has already delivered $6 million in annual run-rate savings.
What’s next?
While guidance for revenue for FY23 was lowered to a range of $780 million to $800 million (from $800 million to $840 million previously), profitability is now expected to be higher, with EBITDA margins now anticipated to be around 11% (compared to 10% to 10.5% previously).
Integration of Over the Wire remains a high priority for the Company, and Aussie believes they are on track to increase the projected annual savings to $8-12 million (from $6 million) by FY25. The merger is also anticipated to support growth in the business, enterprise and government segments – a key focus for the Company as it seeks to build on its success in retail broadband. The fibre buildout will also support the Company’s business and enterprise endeavours, allowing it to connect customers directly, resulting in much higher profitability.
DGL Group Ltd (ASX: DGL)
The Business:
Founded in 1999 by Simon Henry, DGL is a specialised chemicals business that offers a full suite of solutions from manufacturing to distribution, disposal, and recycling. It operates three distinct segments:
Chemical manufacturing (agriculture and home gardening, automotive and trucking, mining and construction, water treatment);
Warehousing and distribution (storage, transportation and logistics required to deliver chemicals and hazardous goods);
In summary, it does everything from manufacturing chemicals, collecting them, storing them, and transporting them to more than 4,500 customers across Australia and New Zealand. It also provides treatment, recycling and disposal solutions at the end of the chemical’s useful life.
What happened in 1H FY23?
Sales revenue up 52% YoY to $217.2 million
Operating earnings (EBITDA) up 30% YoY to $29.7 million
Net Profit After Tax (NPAT) up 22% to $10.4 million
Operating cash flow up 47.4% to $22.4 million (conversion of ~108%)
Net debt increased $34.7 million to $79.8 million (~1.1x FY23 EBITDA guidance)
DGL continued its history of strong financial growth, using its playbook of both organic growth and acquisitions. The active customer base expanded 39% since 30 June 2022 to more than 4,500, as it integrated 6 acquisitions and enhanced the transport and logistics fleet to more than 330. Revenue and underlying EBITDA have now grown at a compound annual growth rate (CAGR) of 107% and 77% between H1 FY21 and H1 FY23, respectively.
DGL made significant progress diversifying its revenue base, both in terms of its sector and customer concentration. Agricultural exposure is now 29% of revenue (down from 49% at the IPO), and its Top 5 customers now comprise 26% of the Company’s total (down from 43% at the IPO). Another measure of “earnings quality” also improved, with cash flow conversion reaching 108% – a healthy rebound from the prior half when DGL made some significant inventory investments that dampened cash inflows.
What’s next?
DGL looks set to continue its history of strong growth, increasing its customer base organically by providing a wider range of services and geographical coverage, and making further acquisitions. The industry remains highly fragmented, and DGL has a history of sourcing deals when family-owned businesses undergo an inter-generational change in ownership. The Company upgraded full-year EBITDA guidance by $1.5 million due to the recently-announced acquisitions, and is now anticipating underlying EBITDA to be between $71.5 million and $73.5 million for FY23 (previous guidance was $70 million to $72 million at the Annual General Meeting). The rebound in cash conversion was a pleasing development, particularly given the increase in debt, while the softening in EBITDA margins is something to monitor in future periods. With a rising cost of capital, organic growth and management execution will remain the key points for DGL to continue delivering, particularly capital allocated to future acquisitions.
