Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 356

Corporate bonds: why now and in what structure?

Investment in fixed income is often seen as a residual allocation, made only after an equity and property portfolio has been painstakingly constructed with sector and style diversification closely scrutinised. However, the performance of various fixed income instruments in March and April 2020 clearly shows that the same level of discernment is pivotal when making fixed income allocations.

While the medium-term outlook remains highly uncertain, now is a good time to undertake the detailed work needed to understand which securities and funds have performed to expectations, and those which have seen existing risks magnified or in some cases new risks brought to light.

For investors with a medium-to-long-term outlook, and a preference for income and liquidity, the good news is that the current market is creating opportunities to reimagine defensive asset allocations, which may include quality corporate credit.

Why corporate credit?

An index-unaware, actively managed and globally-oriented corporate bond portfolio offers several advantages:

  • First, detailed credit analysis ensures that all holdings adhere to strict selection criteria aimed at avoiding defaults. Even a well-diversified portfolio can be significantly impacted by an issuer that does not meet its obligations.
  • Secondly, interest rate risks and credit spread risks can be managed to reduce volatility of returns over time. While coupon income is the dominant source of return from corporate bonds, funds with the flexibility to adjust exposure to interest rates and credit spreads can more effectively manage risk in real-time and ideally also use skill to generate additional investment return.
  • Finally, because issuers offer bonds in multiple currencies, an active manager can seek out the best relative value regardless of the currency. Implemented consistently over time, this flexible approach can lead to incremental return improvements.

Whether they be traditional managed funds or listed high yield bonds, Australian investors have never had a wider range of investment options when it comes to fixed income. Most recently, Listed Investment Trusts (LITs) have provided access to the global 'high yield' market for corporate bonds with credit ratings below investment grade. Offering attractive yields, they were enthusiastically adopted by retail investors.

However, the COVID-19 crisis has revealed the Achilles Heel of LITs - the ability of the unit price to trade below the underlying value of the assets (of course, they may also trade above the underlying value but this has not been evident in the recent crisis). Compared with other fixed income options, LITs have displayed equity-like volatility, although distributions continue to be paid. The longer-term risk is that these valuation discounts persist well beyond the duration of this crisis, a precedent evident in Listed Investment Companies (LICs) focussed on equities.

Figure 1: Average product performance, March-April 2020

Source: Bloomberg, company websites. Following are ASX/Chi-X codes - LIT constituents: MXT, NBI, KKC, PGG, GCI. ETF constituents: IAF, VGF. ETMF constituents: ECOR, EMAX, XKAP, PAYS. Hybrids: HBRD.

Quality fixed income remains attractive

Current market conditions have created a real ‘stress test’ of investment options across all asset classes. Take residential property for example. Long seen as a stable option that offered a mix of income and capital growth, scores of investors are now facing the possibility of many months with little or reduced rent, reduced ability to evict troublesome tenants, and a difficult market for sales.

For income investors, the issue is a simple lack of diversification. While corporate bonds can become difficult to sell at times, a corporate bond portfolio provides significant diversification, protecting a continuing income stream even if one issuer runs into difficulties.

Investors with large allocations to liquid cash or government-guaranteed term deposits have contended with reinvestment risk for years now, and sadly continues to loom large. Even though consumer price inflation is expected to remain subdued for some time, falling returns and cash flow from deposit products is impacting a saver’s ability to meet their commitments.

Add to this the likely reduction in equity dividends in response to profit and economic contraction, and self-funded retirees are potentially facing several years of significant income deficiency. Corporate bonds, by comparison, have clearly-defined payment schedules, and the vast majority are mandatory payments that cannot be cancelled or varied without severe consequences for the issuer. After the volatility of recent months, yields on offer relative to deposit products are the highest for some time.

With the economic outlook still highly uncertain, the spreads of lower-rated bonds have (understandably) widened much more than investment grade debt. While it might be tempting to gravitate towards the higher yields on offer in some of these instruments, it is possible that we are only at the end of the beginning of this crisis, rather than on the cusp of a sustained recovery.

If this assessment is right, there is a strong case to tend toward investment grade securities. One key fact supporting this view is that observed defaults in higher-rated bonds are orders of magnitude lower than in the high yield market, a trend proven through countless market cycles. Avoiding defaults is the single most effective way to ensure success in fixed income investing.

Figure 2: Long-term defaults, IG and HY

Source: Moody’s

Being nimble in fast-moving markets

Among the wide variety of fixed income offerings in the market, there has been considerable variability in outcomes for investors over March and April. Given the unprecedented and fluid nature of this crisis, it is difficult to establish any investment views with conviction.

While these uncertainties do extend to corporate credit as they do to all risk assets, this crisis is showing that not all fixed income instruments are created equally. With such an array of securities available in the market, additional work is not just necessary, but crucial to ensure that risks have been adequately weighed against the expected returns. Investors can increase their chances of success by exposure to well-diversified investment grade portfolios with a laser focus on liquidity and remaining nimble in the face of fast-moving markets.

 

Brad Dunn is a Senior Credit Analyst at Daintree Capital. This article contains general information only as it does not take into account the objectives, financial situation or needs of any particular person.

 


 

Leave a Comment:

RELATED ARTICLES

How to generate income without equity risk

Listed bond funds leap into market gap

Investing like Jerome Powell or the Future Fund

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.