mktogether-blogs, Author at TAMIM Asset Management

ASX Small Cap Analysis: Positive Earnings from ClearView Wealth & Centrepoint Alliance in 2023

28/8/2023

In the recent ASX reporting season, two small-cap companies, ClearView Wealth and Centrepoint Alliance, showcased promising results. Although their earnings may not dominate headlines like tech giants such as Nvidia (NASDAQ: NVDA), the progress they’re making is noteworthy for investors and market analysts alike. In the competitive landscape of Australian financial services, how did the closely-linked Clearview Wealth (ASX: CVW) and Centrepoint Alliance (ASX: CAF) distinguish themselves with their 2023 achievements?

ClearView Wealth

Key 2023 Highlights:

Gross premiums surged by 9%.
The 2023 final dividend was increased to 3 cents per share
25% boost in new advice business, with a 41% spike in the latter half of the year.
Market share leapt to an estimated 9%

ClearView Wealth (ASX: CVW) is an ASX-listed diversified financial services company that partners with financial advisers to provide life insurance and wealth management products. In a strategic move expected to finalise in FY24, ClearView is divesting its wealth management division. Historically, in 2021, there was a significant shift when Centrepoint Alliance acquired ClearView’s financial advisory business. Yet, ClearView still holds a 24% stake in Centrepoint. In a prior article, we discussed ClearView’s strategic pivots and spotlighted the company as a potential takeover target here.

The company delivered an increase in gross premiums of 9% to $325 million and raised its 2023 final dividend to 3 cents per share up from 2 cents in the prior period.

ClearView continued to gain ground with new business and an increase in market share. The company saw an increase of 25% in new advice business with a solid end to the year up 41% in the second half alone. Market share is up to an estimated 9% surpassing the previous highs of 8.6% set back in FY19. ClearView shifted its strategy from a customer retention focus in earlier financial years to now honing in on growth which has driven the transformation strategy to launch new products and structural market changes. As financial adviser numbers across the industry begin to stabilise the business see itself in a strong position to take advantage of a further potential market rebound.

Managing Director Nadine Gooderick went on to say:

“Our decision to reset and transform the business in early 2020 by simplifying and investing in our systems, processes and technology, as well as expanding our people capability, is starting to deliver benefits and growth through efficiencies, productivity gains and scale benefits.”

“The Group’s refreshed strategy is focused on leveraging our competitive advantage in life insurance to achieve our goal of becoming a top player in the Australian market.”

The ClearView report set itself up for some lofty goals in FY26.

The company believes it has established a path forward to grow its life insurance business to close in on $400 million in premiums and is targeting Underlying Life Insurance NPAT (net profit after tax) margin of 11%-13% by FY26.

With increasing premiums, market share and a stabilising industry ClearView delivered strong results. Time will tell whether it can continue its momentum and push towards the expansive goals that are undoubtedly exciting shareholders.

Centrepoint Alliance Ltd

Centrepoint Alliance Limited (ASX: CAF) operates in the financial services industry and provides a range of financial advice and licensee support services (including licensing, systems, compliance, training and technical advice) and investment solutions to financial advisers, accountants and their clients across Australia, as well as mortgage aggregation services to mortgage brokers.

Key 2023 Highlights:

Revenue climbed to $43.1 million, 19% year-on-year growth.
4% gross profit increase attributed to $22.4 million expansion from organic licensed advisers and a $20.7 million input from the ClearView Advisory (CVA) acquisition.
Adjusted EBITDA rose 6% to $7.6 million

Centrepoint saw revenue grow to $43.1 million, a 19% increase over the previous comparable period (pcp). The performance by the Company can be attributed to two key factors: a $22.4 million expansion in organic licensed advisers and the $20.7 million contribution from the ClearView Advisory (CVA) acquisition. This flowed through to a 4% rise in gross profit, amounting to $1.3 million above the pcp.

Excluding one-off costs and asset sales, Centrepoint’s operating earnings (EBITDA) rose to $7.6 million, a 6% increase from the pcp. This growth was again driven by the CVA acquisition and organic licensee fee expansion. Profit Before Tax reached $6.6 million, an impressive $4 million increase compared to 2022. The bulk of this increase can be attributed to Asset Sales ($1.8 million), and reduced LTI/One-Off costs ($1.7 million).

Centrepoint’s cash balance increased to $15.6 million, up by $0.9 million from June 2022. The company remains debt free and delivered a fully franked dividend for FY23 of 3 cents per share, increasing from 1.5 cents in the prior year.

Operational Strengths

Centrepoint maintains its status as the third-largest licensee, boasting 511 authorised representatives under its licences, and supporting 196 self-licensed practices with an estimated 797 advisers.

The strength of services firms is their people. Centerpoint’s retention rates remain high, with fewer than 5% of firms switching to another licensee.

The business is seeing its “Lending as a Service” (LaaS) initiative gaining traction, with 30 participating firms and $25 million in settled loans. LaaS empowers advisers to establish lending businesses by acting as authorised representatives under Centerpoint’s credit licence. This approach allows advisers to maintain client ownership while capitalising on the Company’s infrastructure and in-house lending experts for support.

Following a set of solid results and a continued strengthening of its advisor network, shareholders can be optimistic about Centrepoint’s future performance.

Disclosure: Clearview Wealth (ASX: CVW) and Centrepoint Alliance (ASX: CAF) are held in TAMIM Portfolios as at date of article publication. Holdings can change substantially at any given time.

A Unique Opportunity to Access the Ground Floor of Innovation

by mktogether-blogs | Jul 26, 2023 | Market Insight, Technology

A Unique Opportunity to Access the Ground Floor of Innovation

27/7/2023

We’ve written several times about the historic difference in valuation between small and large companies. There’s a number of ways investors could take advantage of this–small cap ETFs, small cap funds, or for the enterprising investor, picking your own individual small cap stocks. Today though, we’re introducing a new, unique opportunity.

In the coming month, TAMIM will be offering access to a venture capital (VC) fund focused on the Start Up Nation. We believe this opportunity has incredible long-term growth potential. This is the second venture capital investment we have offered to our investors, with the first fund launched at the start of 2020. The first fund has done exceptionally well to date and we believe the environment today is even more conducive to launching a venture capital fund.

We’ll provide much more detail at the upcoming launch, but given Israel’s incredible history of innovation, the dramatic changes to public share markets over the past several decades, and the limited opportunity that investors have to access to private markets, we believe it’s a particularly enticing offer.

Israel: A Beacon of Innovation

While Israel is a small nation, covering just 22,145 square kilometres and with only 9 million people, it certainly punches above its weight. It ranked 18th on the 2022 global innovation index and excels in the technology space. Tel Aviv ranked fifth in a study (by U.S. research firm Startup Genome) of the world’s most attractive ecosystems for startups and innovation–behind only the powerhouses of Silicon Valley, New York, London and Los Angeles. In fact, the Chairman of Google’s parent company Alphabet (NASDAQ: GOOG) is quoted as saying “Israel has the most important high-tech centre in the world after the U.S.”

For those new to the Israeli investment world, Tel Aviv has its own stock exchange founded in 1935, which has performed admirably–the TA 125 (the largest 125 stocks by market capitalisation on the Tel Aviv exchange) has returned shareholders more than 5x their money over the past 20 years. Yet it’s a mistake for investors to think that the opportunities to gain exposure to the best Israel has to offer are limited to investing directly on the Tel Aviv exchange (which might be difficult due to an investor’s brokerage platform or investment mandate).The NASDAQ exchange in the U.S., for example, is home to several highly successful Israeli-based companies. These include the likes of:

Check Point Software Technologies (NASDAQ: CHKP), a US$15 billion IT security provider;
Frutarom, a specialist flavours and fragrances developer that was acquired by International Flavors & Fragrances (NYSE: IFF) for US$7.1 billion in 2018; and
InMode (NASDAQ: INMD), a global leader in medical aesthetic devices that now has a market capitalisation of US$3.8 billion.

Even the U.S.-focused Warren Buffett is no stranger to the opportunities in Israel. In 2006, Berkshire Hathaway paid $4 billion for an 80% stake in Iscar, an Israeli metalworking business headquartered in Migdal most known for precision carbine metal working tools. Such was his delight with Iscar, the Oracle of Omaha purchased the remaining 20% for a further $2 billion in 2012–double the original valuation. Yet Buffett has had no regrets, with sources close to the company suggesting that Iscar had returned between $5 billion and $6 billion back to Berkshire over the decade ending in 2019.

These are already large and well-known companies though. While they might continue to generate healthy returns for shareholders well into the future, they’re unlikely to generate the multi-bagger potential that comes from smaller, more unknown startups.

Venture Capital: What is it and Why?

Companies that undertake an initial public offering (IPO) to list on a stock exchange are typically larger, more mature businesses that usually have strong market positions and positive cash flows that allow them to invest in their own expansion and return capital to their shareholders (through dividends and share buybacks). Smaller companies on the other hand, usually need capital–particularly startups. This is where venture capital comes in.

Venture capital (VC) is another form of share ownership for small and startup companies. These businesses typically have very high growth potential, but their products are in the early stages of adoption or they are competing with larger, established players. Because it is higher risk (or at least, more uncertain), it is generally restricted to more sophisticated investors (Marc Andreessen for example). Although it’s a bit different in reality, the television program Shark Tank provides a decent glimpse into the startup and venture capital world.Unless you’re a professional investor or in the industry, rarely do retail investors get the opportunity to invest in promising startups–which significantly reduces an investor’s universe.

The Shrinking Universe

The share market, both in Australia and internationally, has provided investors with huge opportunities to generate long-term wealth for decades. We think it will continue to do so for decades to come and fully support investors developing a long-term, diversified portfolio to support their financial goals. However, one of the challenges with investing in the stock market is the shrinking universe of available investments. A 2017 study by Credit Suisse found that while around 2,500 companies were added to the U.S. stock exchanges between 1976 through 1996, the number of listed companies fell by 3,650 after 1996–a whopping 50% of companies disappeared in the next 20 years!

Part of this is due to regulation. The Sarbanes-Oxley Act of 2002 created a host of new standards for listed companies (regarding the Board of Directors, management teams, accounting firms, etc.), which noticeably increased the cost of being public for small companies. There’s also more scrutiny on public companies, such as the pressure to hit quarterly earnings targets, ESG requirements and the like, leading to frustration amongst management teams that they’re not able to focus on the company’s long-term strategy. Mergers and acquisitions have also increased, leading to more concentrated industries with fewer large companies (anti-trust regulators have been increasingly concerned by this).Overall, these factors (among others) have encouraged companies to stay private for longer. In fact, CB Insights believes that there are currently more than 1,200 unicorns–private companies with a valuation of more than US$1 billion, many of which would have been listed on a stock exchange in times past. The IPOs of late have been of extraordinarily large private companies, such as:

Alternative accommodations behemoth AirBNB (NASDAQ: ABNB) debuted at a valuation of US$103 billion in 2020; and
Ride-sharing behemoth Uber (NYSE: UBER) which listed at a valuation of US$82.5 billion in 2019;
Music streaming giant Spotify (NYSE: SPOT), whose IPO valued it at US$29.5 billion in 2018.

This has led to endowments, superannuation funds and other sophisticated investors gaining better access and increasing their allocations (and ad higher allocations to alternative investments–including private equity and venture capital.

Rare Opportunity to Diversify Your Portfolio/Favourable TIming?

The valuations of high-growth companies, including listed technology and private venture capital businesses, soared during the coronavirus pandemic. Investor participation surged, interest rates and the cost of capital plummeted, and the investment community wildly extrapolated that a bigger proportion of the economy would shift online than has proven to be the case.

While valuations for most of these businesses have since moderated, the so-called “megacap” stocks have rallied back to near-record highs. Nvidia and Microsoft are the poster children, fuelled by the recent artificial intelligence announcements, including ChatGPT. Smaller companies, however, have not seen the same rally, and we’ve written before about the huge discount of international small cap stocks relative to their history–currently at the biggest gap since the dotcom bubble.We’re optimistic about the outlook for small companies and believe now is a great time to offer this unique VC opportunity to Australian investors to get in on the ground floor of Israel’s next wave of innovation.

Diversification: Can You Have Too Much?

by mktogether-blogs | Jul 12, 2023 | Economy, Market Insight

Diversification: Can You Have Too Much?

13/7/2023

Diversification is no secret, it’s a well-known part of investing. “Don’t put all your eggs in one basket” is a common phrase that we learn at a young age, and something that most people put into action, at least to some degree–usually after we make a big mistake, or see one made by a partner, friend, or family member.

Diversification is important. It’s a hedge against our inevitable mistakes and an uncertain future, and protects us against losing too much money–an amount that would impact our lifestyle, undo years of hard work and savings, or in the case of professional investors, cost us our job. But, how much is enough? And can you have too much of a good thing?

Time and Effort

Renowned investor Peter Lynch delivered a compounded return of more than 29% per year between 1977 and 1990 at Fidelity Investments. In his flagship Magellan Fund, Lynch typically held more than 1,000 stocks (and often as many as 1,400 different companies) in the portfolio.

The average investor, though, likely only has the capacity to properly monitor up to 30 individual companies–especially if they have a day job that isn’t investing, children or other family members to care for, or any other hobbies or life challenges to occupy their time. The average investor also doesn’t have the same level of access to company management, nor a team of analysts, a Bloomberg terminal, institutional research reports, and IPO prospectus materials. It’s also worth noting that Lynch retired at the sprightly age of 46, such was the toll of his investing career.

Diversification

Warren Buffett, on the other hand, is famous for his concentrated investing style that has generated incredible returns for Berkshire Hathaway shareholders over decades. Investors almost immediately associate Buffett’s name with the likes of Wells Fargo, Coca-Cola, American Express, and nowadays, Bank of America and Apple. Buffett has been quoted as saying: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

As well as being the most sophisticated and talented of investors, Buffett has a clear reason for his concentrated strategy. He wants to always allocate new funds to his best idea, and his best idea is usually something that he already owns (a lot of!). Although this is outdated given the bank’s subsequently-aired scandals, Berkshire’s vice-chairman Charlie Munger described this strategy succinctly: “Our best idea is Wells Fargo. And we would compare every stock that we’re looking at to Wells Fargo. If it’s not better than Wells Fargo, why not just buy more Wells Fargo?”

Cutting Flowers and Watering Weeds

The mantra of diversification often causes investors to sell their winners and add to their losers–a process Lynch described as “cutting the flowers and watering the weeds.” This is often counter to a successful investing process. It’s well-known that a portion of investments won’t be successful and in fact, an investor who picks 6 winners out of every 10 will usually be richly rewarded. This is because the gains from some stocks will be so large over time that they will significantly outweigh the losses or mediocre returns for the others.

The success of these great performers will cause them to become an outsized portion of the portfolio at times, and diversification encourages people to sell. On the other side, poorly performing stocks will become so small that investors will be encouraged to add to these positions. As Frank E. Block wrote in “The Elements of Portfolio Construction” all the way back in 1969: “more often than not, both moves turn out to be mistakes.” Taken to the extreme, one good investment in Amazon in 1997 has turned Bill Miller from Miller Value Partners into a billionaire (he also credits his more recent Bitcoin purchases).

Overlapping Exposure

Beginner, time-pressed and less passionate investors often look to exchange-traded funds (ETFs) for a simple, low-cost way to invest with adequate diversification. There has been an explosion in the number of ETFs available over the last decade, providing investors with exposure to different geographies, sectors, themes, and company sizes. Unfortunately, the fine print often outlines something different than one would expect, and there can often be significant overlap between products. For example, according to data from ETF.com, 321 ETFs held shares in ExxonMobil as of mid-2023.

Adding an additional ETF to a portfolio may not provide any additional diversification benefit. Even with individual shares, an investor might think they are gaining diversification by increasing the number of companies. While this is true to a certain extent, if they are within the same industry or have other overlapping features (e.g., macroeconomic risks), the extra benefit may be minimal.

Your Personal Balance Sheet

One aspect that doesn’t get much attention but is worth remembering is the size of an investment relative to your overall net worth. While a stock may represent 10% of your share portfolio, it may only represent 5% (or even much less) of your total assets–particularly given the value of the family home for most homeowners in Australia. Thinking about it in this way may significantly change how comfortable you are with the size of a particular position.

The Big Question: How Many Stocks?

While the numbers may vary slightly, the theory in financial courses is remarkably consistent. Diversification provides enormous benefits starting from your initial investment until you build out a portfolio of at least 5, and preferably 10, (lowly-correlated) investments. The benefits of diversification begin to decline substantially after 15 stocks, and even more after 30.

Portfolio Volatility vs. Number of Investments

Source: Multi-Asset Investing: A guide to modern portfolio management. Lustig, 2013.

These guidelines relate to both “volatility” and “risk”, which some investment professionals use interchangeably (a topic for another day). Block’s article described it as a “probability of success.”

Probability of Success vs. Number of Investments

Source: Frank Block, 1969, The Elements of Portfolio Construction, Financial Analysts

What’s the Answer?

The best reason for greater portfolio concentration is higher returns. Truly special companies are rarer than you might expect and focusing on your best ideas is one of the best ways to achieve long-term investing success–particularly if you let these ideas flourish and don’t trim them prematurely. As the ever-quotable Buffett said: “Diversification may preserve wealth, but concentration builds wealth.”

Yet the future is an uncertain place. The unexpected can happen at any time, as we’ve seen in recent times from the pandemic, the outbreak of war in Ukraine, and the rapid change in interest rates and inflation.Concentration can have a dramatic impact if things go the wrong way. Ruane Cunniff & Goldfarb Inc.’s Sequoia Fund tarnished an incredible long-term track record by allocating up to 15% to the infamous Valeant Pharmaceuticals, damaging their reputation and causing conflict inside the firm.

This personal impact is often the most under-appreciated factor. While there’s no doubt that greater concentration can produce better returns (if executed well), it can still take its toll. Joel Greenblatt delivered a phenomenal 50% annualised return between 1985 and 1994 at Gotham Capital using a portfolio that generally held 6-8 investments. He acknowledged, however, that it often kept him up at night. As described above, Peter Lynch retired at just 46.

Ultimately, the best level of diversification will be what you’re comfortable with and allows you to make smart investment decisions that keep you invested, to reap the benefits that long-term share ownership can bring.

What is a recession and what does it mean for investors?

by mktogether-blogs | Jul 6, 2023 | Economy, Market Insight

What is a recession and what does it mean for investors?

6/7/2023

Fearing a recession is natural. Recessions are an economic reality. They typically start before anyone realises they’re happening and end before economists have enough data to know they’ve finished.

It’s understandable to worry considering the constant headlines dance between inflation, interest rates, the cost of living crisis and the mortgage cliff. For investors, a recession may seem daunting at first, but its actual impact can be less severe than the media suggests.

We all hope that the Reserve Bank of Australia (RBA) can pull off a soft landing for our economy over the rest of 2023 and into 2024. But sometimes, it’s best to hope for the best and plan for the worst.

In order to do so, we think it is crucial to understand the business cycle and get clear on the intricacies of recessions.

The business cycle

The business cycle is made up of four phases broken down into expansion, peak, contraction and trough which looks at the growth and output of the economy. The output is considered real gross domestic product or GDP and is an inflation adjusted measure reflecting the value of all goods and services produced by an economy in a given year. While the phases are fairly self explanatory, expansion is when everything is booming, workers are being hired, wages are going up and households are purchasing more goods. This all ends at the peak before beginning a move into the contraction phase where employees are laid off and wage growth slows leading to less goods being purchased by households and a reduction in demand. The end of the contraction phase is the trough in economic activity.

So what exactly is a recession?

There are many definitions of a recession depending on the data you utilise and where in the world you live. What is common between them is the changes in economic output and the labour market. One of the more common terms used is a ‘technical recession’.

A technical recession is defined as two consecutive quarters of negative growth in real GDP and is the common definition you’ll read about online or in the newspaper. Prior to the Covid-19 Pandemic Australia hadn’t seen a technical recession since the early 1990’s which is an unusually long time. There are some weaknesses in the technical definition, for example:

If GDP had quarterly growth that was negative, followed by flat, followed by negative the economy may be looking weak but would not have realised a ‘technical’ recession.

GDP numbers can be revised at a later date once more information becomes available. This can lead to both positive and negative changes to the GDP figure. Seasonality can also mean GDP numbers are volatile leading to large fluctuations in GDP growth. These factors can lead to false reads on how the economy is actually performing.

GDP can grow due to population growth and the pure increase in output by having a greater number of contributors. A technical recession doesn’t consider that per person the GDP may be decreasing. This is considered GDP per capita and is used by some economists to exclude population growth from the GDP calculation.

A recession definition with less focus on GDP is one that is based on unemployment numbers.

The unemployment based rules are generally straightforward and take into account a predetermined increase in the unemployment rate. While simple in nature it again has some limitations, particularly around underemployment which looks at how well the labour force is being used within the economy and whether employees could be working additional hours.

What does this mean for investors?

It can be a scary time when all headlines point to doom and gloom and there are plenty of reasons to exit the market. Thesis’ are tested and external noise can impact share prices even though the fundamentals of businesses may not be impacted in the long term.

It’s important to take a step back and remember your investing goals.As a long term investor it’s paramount to remember that downturns and recessions don’t last forever and they can potentially provide terrific buying opportunities. It’s crucial to consider the reasons why you’re invested in an asset in the first place and a good point in time to review your conviction in a position.

Taking a look at past performance of markets during and post significant downturns you can see that these drawdowns can bring opportunity to the right investment. While almost impossible to time the top and bottom of markets, a dollar cost average approach into high conviction well researched positions could lead to long term gains.

From an index standpoint you can see from the below graph some of the larger drawdowns in the S&P 500 index and the subsequent performance. Had you exited during these periods you would have missed some incredible growth from that point on.

Not only growth but some of the world’s best businesses were developed during recessions.

Disney (NYSE: DIS) was launched in 1929 right before the great depression. The company navigated its way through four years of difficulty to produce its first feature film at the conclusion of the depression. It has since become a $165 billion dollar company.

Netflix (NASDAQ: NFLX) was established in 1997 pre dotcom bust. It didn’t take long though before things turned south and they approached Blockbuster to purchase a large part of the business. They were laughed out of the room but ultimately had the last laugh as they became the streaming mega giant they are today leaving Blockbuster for dead.

AirBnB (NASDAQ: ABNB) was created pre the GFC, born out of an idea to rent out air mattresses (the air in AirBnB) in the founders apartment floor so they could cover rent. The GFC hit and people began looking for more affordable accommodation options as well as a new way to make money. This created a new challenger for the hotel industry and the rest is history!

So rather than running from the markets if a recession is on its way it may be an opportunity to discover the next big businesses of tomorrow.

A little closer to home had investors left the market during the peak fear of the COVID-19 Recession they would have missed some significant share price appreciation.

Since late March 2020 companies such as REA Group Limited (ASX: REA), Fortescue Metals Group (ASX: FMG), Telstra Group (ASX: TLS) and Xero (ASX: XRO) are just some of the many companies that have bounced back off their lows.

Of course, TAMIM portfolios have seen similar movements. We’ve spoken about Helloworld Travel (ASX: HLO), IPD Group (ASX: IPG) and Silk Laser Australia (ASX: SLA) recently – all these companies faced share declines through 2020-2022 as the world faced extraordinary economic challenges but have rebounded strongly as conditions improved.

The following Morgan Housel quote is about markets but is also transferable to recessions:

“Every past market crash looks like an opportunity, but every future market crash looks like a risk.”

The TAMIM Takeaway

Whether we are about to enter a recession or not as investors it’s not a time to panic. Rather, take stock of what you are invested in and find businesses that you are confident will be prospering in the long term. A recession or significant downturn can sharpen your focus on those companies that have the characteristics to be long term winners and weed out the losers. The game doesn’t change but potential opportunities do arise in falling markets.

Disclaimer: Helloworld Travel (ASX: HLO), IPD Group (ASX: IPG) and Silk Laser Australia (ASX: SLA) are held in TAMIM Portfolios as at date of article publication. Holdings can change substantially at any given time.

Bond Basics for Beginner Investors

by mktogether-blogs | Jun 28, 2023 | Market Insight

The Financial Times (FT) recently reported that for the first time, the S&P 500, corporate investment-grade bonds and treasury bills are all offering the same yield of 5.3% for prospective investors. The leading financial newspaper provided a useful graphic depicting the three respective yields over the past decade.

Price-to-Earnings or Earnings Yield?

By including the S&P 500 in this group, the FT is referring to what is called the “earnings yield,” which is the inverse of the well-known price-to-earnings (P/E) ratio. For example, a company that has a market capitalisation of $200 million and earns a profit of $10 million would have a P/E ratio of 20x (P/E ratios are often quoted as last twelve months “LTM”, trailing twelve months “TTM”, or next twelve months “NTM”, each of which refer to when the $10 million in profit was or will be earned). A P/E of 20x equates to an earnings yield of 5% (i.e., 1/20 x 100 = 5%).

Alphabet Soup

Corporate bonds receive credit ratings that assess their risk of default (not paying investors interest or principal) from agencies including Standard & Poor’s (S&P), Moody’s and Fitch. These ratings range between AAA (meaning an extremely strong capacity to meet financial commitments) and D (in default) by S&P and Fitch, and from Aaa through C for Moody’s. The higher parts of these ranges are known as “investment grade” (BBB/Baa3 and above) and the lower parts of the ranges (below BBB/Baa3) are referred to as “non-investment grade” or “speculative grade”, or more commonly, “high yield bonds” or even “junk bonds.” This is quite an important distinction because investment grade companies are far less likely to default during times of economic stress and their cost of debt is much lower than speculative grade companies.

Risk-Free (Mostly)

Treasury bills (T-Bills) are short-term government bonds typically ranging in duration from one month up to one year. T-Bills do not pay the investor a coupon. Instead, “interest” is the difference between what the investor pays and what they receive when the bill matures. For example, based on the 5.3% quoted by the FT above, an investor that purchases a one year T-Bill for $95 would receive $100 at the end of the 12-month period. T-bills is more of the convention for the U.S., whereas short term government bonds are usually called Treasury Notes in Australia

Are All Yields Created Equal?

The FT article categorised the three different potential investments as medium risk (S&P 500), low risk (corporate bonds) and no risk/risk-free (treasury bills). It also stated that “investors lose the incentive to own US equities,” implying that with each of the investments yielding 5.3%, investors should prefer T-bills and corporate bonds over the S&P 500.

All else being equal, it’s true that investors should prefer government bonds over corporate bonds. Companies risk defaulting on their debt obligations, giving investors what is referred to as credit risk. A government that issues debt in its own currency, such as the United States or Australia, on the other hand, is likely to be able to raise taxes if they need additional funds to meet their financial commitments. This is why corporate bonds usually pay a higher interest rate than government bonds [Johnson & Johnson, NYSE: JNJ, and Microsoft, NASDAQ: MSFT, are rare companies that also carry the highest AAA credit rating]. This difference is known as the “credit spread.”There are times though when investors might prefer corporate bonds over T-bills. For example, if an investor thinks that the economy is going into a deep recession and interest rates are likely to fall, they may prefer a longer-duration corporate bond (perhaps 5 years or 10 years) with a similar coupon rate to the short-term government bond. This is because the investor will continue to receive the stated interest rate for the full 5 or 10 years on the corporate bond, while with a T-bill, they will have to find a new investment within 12 months that might pay a lower interest rate (the central bank can lower interest rates as quickly as they raise them, as we saw during the early days of the pandemic).

The S&P 500 might also still be the best option for some investors. Inflation can be a real dampener on the profit margins of some companies–particularly those with a lot of labour and material costs. Other businesses, though, have extremely good inflation protection. These include infrastructure companies (that have already built their assets and are able to lift prices, such as an airport, toll road or pipeline), brokerage services (insurance or mortgage brokers for example, that take a commission based on the nominal cost of a product or service), and certain other financial institutions (in many cases banks, who again deal in nominal prices). There are also businesses that provide such a great product or service to their customers that they are able to raise their prices without reducing demand, an attribute known as “pricing power.” Bonds, on the other hand, can be severely impacted by high inflation and rising interest rates.

What Happens to Bonds When Interest Rates Rise?

The Australian Financial Review (AFR) recently published an article entitled “Australian investors have no idea how bonds work.” It suggested that while more than a quarter of Australian investors are confident that bonds will outperform equities in 2023, around 64% did not understand what happens to bonds when interest rates rise. This data was based on a survey of 8,550 individual investors with more than US$100,000 in assets conducted in March by Natixis Investment Managers, a US$1.2 trillion (AU$1.8 trillion) global asset manager.

The results of the survey were dismal around the globe, with only 1.7% of international investors selecting the correct answers–that when interest rates rise, the current price of a bond decreases and future income increases. While Taiwan (5%) and Hong Kong (4%) had the highest rates passing the quiz, Australia performed extremely poorly at only 0.5%. The 64% of Australians who responded “I don’t know” was nearly double the second-worst result, which came from the Netherlands.Only 18% of Australian respondents said they had invested in bonds–a figure that might be an overestimation. The survey included only 400 Australians and the recent ASX 2023 Investor Study showed a much lower result, with only 6% of Australian investors having bonds in their portfolio!

Boost Your Bond Knowledge

The rapid rise in interest rates over the past 12-18 months has made bonds a far more interesting investment than at any time since the Global Financial Crisis. Bonds are a very useful asset class that can provide investors with stability, income and much-wanted diversification. They come in all shapes and sizes: durations between 1 month and 30 years, they are issued by corporations and governments, they pay coupons based on fixed and floating interest rates, some of which are linked to different inflation rates, and in a variety of currencies. There are certainly reasons to continue investing in growth assets including shares and properties, but now could be a great time to boost your knowledge and take advantage of the emerging opportunities in the enormous global bond market.

« Older Entries

Next Entries »

ASX Small Cap Analysis: Positive Earnings from ClearView Wealth & Centrepoint Alliance in 2023

ASX Small Cap Analysis: Positive Earnings from ClearView Wealth & Centrepoint Alliance in 2023

ClearView Wealth

Centrepoint Alliance Ltd

A Unique Opportunity to Access the Ground Floor of Innovation

A Unique Opportunity to Access the Ground Floor of Innovation

Israel: A Beacon of Innovation

Venture Capital: What is it and Why?

The Shrinking Universe

Rare Opportunity to Diversify Your Portfolio/Favourable TIming?

Diversification: Can You Have Too Much?

Diversification: Can You Have Too Much?

Time and Effort

Diversification

Cutting Flowers and Watering Weeds

Overlapping Exposure

Your Personal Balance Sheet

The Big Question: How Many Stocks?

Portfolio Volatility vs. Number of Investments

Probability of Success vs. Number of Investments

What’s the Answer?

What is a recession and what does it mean for investors?

What is a recession and what does it mean for investors?

The business cycle

So what exactly is a recession?

What does this mean for investors?

The TAMIM Takeaway

Bond Basics for Beginner Investors

Price-to-Earnings or Earnings Yield?

Alphabet Soup

Risk-Free (Mostly)

Are All Yields Created Equal?

What Happens to Bonds When Interest Rates Rise?

Boost Your Bond Knowledge