How to generate income without equity risk

Hi Graham – TANSTAAFL ... I should have trademarked that word! I thought I coined it personally when putting together a public talk for a director I reported to when working for a while with a public company – in those day still a family run company. It went down very well! Great to see it being used more publicly still! Of course it may have been sourced before I used it but honest guv I didn't know. Hope you’re well and the editions remain a very consistently good read. Cheers carlo

Amazingly helpful, thanks so much. surely though, the experts really make their money by trading in and out of various bonds / ETFs etc at the 'right' time?

I have addressed falling ‘risk free’ returns by adopting a barbell risk approach – keeping 80% in cash and physical gold and taking more risk with 20% in Aussie equities. One thing the GFC highlighted was the importance of diversification, especially credit risk. Innovation and disruption of established industries like banking and healthcare have a long way to go providing some excellent risk reward tradeoffs. Given the downward trajectory of $A, the article makes no attempt to maintain or even enhance the wealth of a global citizen who happens to live in Australia

Interesting article. I found it helpful.

One of the most critical bits of information you need about any fixed income investment – be it a single bond, a managed fund or a listed vehicle – is the yield to maturity when you make your investment in it. That will always be the single best estimate of the return you’ll get from this investment.
For a single bond, it’s an almost 100% accurate estimate, but for a portfolio it’s still a very good predictor. With one proviso. You also need to know the maturity of the bond or the average maturity (duration) of a portfolio. The yield will be the return over that period. Over shorter periods, the return will be dominated by capital price fluctuations; and over long periods, reinvestment of maturing bonds will result in a different yield profile.
The one thing that’s totally irrelevant is the return historically, in particular the return last year. Lots of bond funds and bond investments have had stellar returns in 2018-19, because the fall in yields has created capital gains. All that really means is that the returns embedded in yields 12 months ago have partly been brought forward and per annum outcomes over the remaining maturity period will be lower.
You’ll also need to look a lot further for useful information than the ASX website. It’s set up as if ETF’s and LIC’s are shares, so doesn’t give the forward looking information that you really need for bond portfolios.
Let me illustrate by checking out one of the funds Graham has mentioned. Totally arbitrarily I’ve chosen the Russell Select Corporate Bond ETF (ASX.RCB). I’ve tried to work out what’s going on with this fund by looking at the ASX website for it; then I’ve gone to the Russell website.
The ASX website tells me that this is a 0-3 year fund. By contrast, the Russell website tells me that this is a 0-4 year fund. Let’s ignore that difference for a moment. Either way, this tells me that the fund’s price won’t be too volatile, as it’s in some way going to be focussed on shorter term bonds and not 10 year bonds. This lack of volatility is confirmed by the chart that the ASX gives me that shows a price between around 20 and just over 20.5 over the past few years.
The ASX shows me the dividend history. This year (2018-19) we had 3 interim divs of around 14 c each and then a final div that’s much larger at 44c. It’s usual for any managed fund (and an ETF is just a managed fund that’s in a listed vehicle) to hold back some of the income accrued during the year so that the final quarterly payment is a bit bigger, not smaller, than the others. But such a large jump suggests to me that there’s been some realised capital gains that have had to be distributed as well.
I’d have an idea of how much that is if the website gave me a history of the average yield to maturity of the portfolio. Then I could look at what it was a year ago and compare that to the realised dividend yield of 4.3%. I’ll get that from the Russell website, but if all I was relying on was the ASX then this is how I go about it.
What I’ve done is to work out the average yield that the 3 interim divs represent, per annum, which is about 2.7%. (Add them up, divide by 3, multiply by 4 and then divide that by the price at the start of the year.) Assuming a little bit of income was held back each time, then it seems that the underlying income earnings of the fund were about 3%. So the final dividend reveals about 1.3% of capital gains that have been distributed. But this is just a rough estimate from imperfect information.

So, now I go to the Russell website and, voila, they tell me there that the ‘running yield’ of the portfolio is 3%. So my calcs seem to be on the money. I can also find out that the total return of the fund last financial year was 7.2%, including 2.7% from growth, on top of the distribution return. That figure shows me the unrealised capital gains sitting in the fund.
What we have then is a yield or income amount of about 3%, plus 2.7% of unrealised gains and another 1.3% of realised gains paid in the distribution. So that’s 4% of capital gains.
That makes sense since Russell also tell me that the duration of the fund is 3.5. I know from other sources that bond yields in the 3-4 year part of the market fell during 2018-19 by about 1.1%. Multiplying 1.1 by 3.5 is 3.85, which is close to 4% so we’re in the ballpark.
The Russell website also tells me that at 30 June the ‘yield to worst’ (similar to the yield to maturity) is 1.75%. They don’t give me historical information, but I’m inferring that a year ago this yield to worst number would have been more like 2.85%, adding back the 1.1% that I know about from general market information. That drop in yield produced the capital gains that boosted last year’s return, but now means that, going forward, I can expect the total return on an investment in this ETF to give me 1.75% per annum before fees over the next 3-4 years.
If yields fall another 1% this year, then the fund will give me a solid return of about 5% after fees. But after that, yields will be at 0.75% so the return in the next couple of years will be down at that level. Do the math – a year 1 return of 5% followed by 0.75% per annum for 3 more years delivers an average result of 1.75% per year.
Every fund will be nuanced, holding different bonds. You have to take credit risk into account – some could lose capital if there’s a default. But the core maths of how to understand what you’re getting into needs those two bits of information at the very least – yield to maturity and average maturity (or duration) when you make the investment.

And finally, the prospective return on this Russell investment is not all that different to term deposit rates on 3 year terms at the banks at the moment. That’s not really surprising since the holdings in this ETF are all bank bonds maturing in 2022 and 2023. So that’s one more bit of information worth getting about an ETF – the securities it holds. Again, you can’t get that from the ASX website, you need to go to the manager.
Let me then call on the ASX to improve the quality of its information on bond ETFs and the like as a service to investors.

Hi Warren, to educate us further could you explain your preference for Yield to maturity vs Running Yield and the difference. For example the Vanguard Aust Fixed Interest Fund has a Yield to maturity of 1.41% and running yield of 3.43% – a big difference in estimating solely income. Which is more correct?

It’s not a case of one being “more correct”. It depends on what you’re trying to figure out.

Running yield is the amount of income divided by the current market price. It’s a simple calculation, similar to dividend yield on stocks.
Yield to maturity is based on the Net Present Value (NPV) of income and capital amortisation. This gives a better estimate of total return over the life of the bond.

So a $100 bond trading at $95 with a coupon interest rate of $4 has a running yield of 4.2% (4/95). But the yield to maturity of that bond is more than this because it takes into account the amortisation of that bond back up to $100 at maturity.

In this case, the yield to maturity is higher than the running yield because amortisation is positive – the bond’s capital value increases. How much depends on the maturity of the bond. If it’s 5 years from today, then amortisation is $1 a year, so the yield to maturity will be an NPV calculation based on $5 of income a year = $4 in interest + $1 capital appreciation. That will be a bit over 5%.

Yield to maturity is, most of the time, similar to running yield. But when you’ve had a big move in the market since the bond was issued, you’ll get a difference like in the example I just gave, in which yields have risen and the bond’s price has fallen below par.

Or in the Vanguard case you’ve mentioned, yields have fallen for most of the bonds so that the average price is above par. That means there’s negative amortisation to be deducted from the running yield when the yield to maturity is calculated.

It looks like this Vanguard fund will pay a distribution income rate of 3.4%, but the unit price will drift lower by around 2% a year to give a total return over time of 1.4% pa.

Most funds, rightly, say that their yield to maturity is ‘not a forecast’ of the return. That’s because a fund is dynamic, with bonds being traded and strategy for variables such as duration being adjusted quite often. Those things will affect the outcome. So, from a legal disclosure point of view, that proviso is correct. However, yield to maturity is the best starting point you have for estimating the total return, especially when comparing different funds.

That’s a very partial answer, but I hope that it helps. I feel another article coming on.

This article + Warren’s comment would probably be the most educational content I have ever read on fixed income. Thank you very much!

Thanks for the kind comment, Lee. Yes, many people need to learn more about fixed interest opportunities. G

How to generate income without bond risk – and without sweating?

The Everything Bubble is providing capital gains but reducing current and future yields.

When Yield on Everything disappears down the same black hole and capital gains alternate wildly with capital losses, we will see the birth of a new ‘Alice in Wonderland’ investing universe the mirror image if this one.

Ah Dudley, you need to read a few of my articles. e.g.

https://cuffelinks.com.au/journey-life-fixed-rate-bond/

https://cuffelinks.com.au/really-bond-returns-market-rout/

Even if bond yields rise, over the life of the bond or over a period similar to the average maturity of a fund an investor will still earn the yield at which they purchased the investment.

It would work the opposite of the example I gave in my comment. Buy at 1.75% and watch yields go up by 1% in year 1. In the situation I was talking about that gives a negative return in year 1 of about -2%. If yields stayed there, then in years 2, 3 and 4 the investor will earn around 2.75% per annum. That delivers a positive return of 1.5% per annum over 4 years, without taking into account any reinvestment earnings at the higher yield.

No denying that if you believed that yields were going to post that 1% increase then you’d avoid making the investment then and wait until you could do so at 2.75%. Folk have been doing that since at least 2012 when I spent several months giving presentations to investors urging them not to think that another 1994 was about to hit us. They’ve missed out opportunities to lock in the sort of rates that Graham’s article mentioned.

Now yields are at record low levels. That’s not a bubble. For two reasons.
First is that yields aren’t here because of speculative excess. They’re here because economies aren’t generating a risk free rate of return higher than inflation. We had the cash rate at 1.5% for 3 years and yet the economy chugged along at trend and we didn’t get inflation. If the RBA had artificially forced the cash rate to be ‘too low’ then we would have inflation, but instead it keeps falling and we now believe that even 1% cash isn’t going to work without other sources of stimulus for growth in the economy. (This is a short version of my article https://cuffelinks.com.au/response-montgomery-bond-signals/)

Second is that you can’t have bubbles in bonds. It’s not how the asset class works. Every bond matures at par and the amortisation of bond prices from current levels to par is factored into the yield to maturity so it’s not a surprise. A bubble market results in permanent losses of capital and severe negative returns that can’t be recouped. That’s simply not the case for bonds. You will earn the income and bonds will mature at par!

So, no need to sweat going into bonds right now. If yields go up from here, then you’ll see a negative return early on, but returns in future years will be more than the yield to maturity today.

People have to think about bonds differently to equities – they’re different asset classes entirely.

Lothe to side track but the underlying the premise of bond certainty is the assumption of 100% certainty of par value being paid at maturity. Beware Greek bonds.

Not a sidetrack, Dudley. I did say that there’s more to it than just YTM and duration, though they are the foundational aspects of estimating returns.

Credit risk is part of the story when you invest in bonds. (And as Ashley has written about a couple of times, even governments like Australia have defaulted in the past. It’s extraordinarily rare, though, and easy to exaggerate the probability of it happening again, but AAA bonds don’t have a zero default rate.)

I’ve written about credit risk, too, (surprise, surprise) – in particular these two articles:

https://cuffelinks.com.au/give-risk-credit-deserves/

https://cuffelinks.com.au/managing-credit-risk-requires-healthy-dose-cynicism/

Key point, though, is that credit risk is a risk to be managed, not a killer for the asset class. If you diversify properly, as I advocate in those articles and have advocated many times since in various places, then:
(a) defaults in your portfolio will be very rare, if at all. In the universe of Investment Grade bonds (AAA, AA, A and BBB) the average default rate is around 2.5%;
(b) losses from defaults will be even less than this because there’s recovery in most situations; and
(c) the asset class will deliver you an attractive return. Which almost all of the time will be driven mostly by the yield to maturity of the bonds in your portfolio.

Therefore, the assumption that bonds reach par at maturity is totally valid and empirically justifiable for sovereign and investment grade bonds.

When you get into high yield bonds, there’s a greater chance of losses. But again, they’re manageable and I think it’s a great asset class to be invested in, as I wrote about here: https://cuffelinks.com.au/invest-junk/

Finally, Greek bonds didn’t actually default. They were bailed out because of the commitment of other Eurozone nations to preserving the Eurozone. The bail out is a heavily deferred loan from the EU, so the European entity has accepted what would have otherwise been default losses to investors who had shorter term maturities than the 60 years or so that Greece now has to make payments. But the fact that Greece is part of a group of nations committed to its members in this way is an important part of the risk assessment of Greek bonds.

So, you can’t flippantly dismiss an entire asset class on the basis of one example.

Into the looking glass:

Greek 10-year yield dips under 2% for first time ever, back below US 10-year
https://www.cnbc.com/2019/07/25/reid-190725-bonds-yields-greece-eu.html

ECB Loads Up Stimulus Salvo as Draghi Laments Worsening Outlook
https://www.bloomberg.com/news/articles/2019-07-25/draghi-signals-worse-and-worse-outlook-warrants-ecb-stimulus

Amazing that they don’t mention investing in Non bank first mortgage loans that yield from about 5 to 10% pa.

Hi Kevin, this article is specifically about listed securities. Happy to hear about listed securities that invest in first mortgage loans. G

Hi Graham, thanks for the XTB mention. You note that one loses the diversification of ETFs when you buy individual bonds, just as you do when you buy individual shares.

But to complete the picture: with individual bonds you also retain one of the most critical features of fixed income investments (for many investors), which is the utter predictability of prospective or future returns if you hold fixed rate bonds to maturity – being the prospective Yield to Maturity that Warren explains fully above.

With any perpetual ETF or fund you automatically lose this predictability because putting maturing bonds (the bond feature that delivers predictability) into a perpetual vehicle results in the loss of both income and capital predictability (as bonds are replaced as the mature).

Its why in the US they see bonds held individually, and bonds in funds/ETFs as different (but related) asset classes because the investment outcomes are so different.

Not the case with equity + equity ETFs, which are both perpetual. So ETFs don’t “mirror” owning bonds as they do for equity, currency, commodities. hence US morphing to maturing ETFs.

Depending on the type of investor – this can actually be fundamental to why bonds and the fund/ETFs are not the same thing. For investors like TD investors who are used to and need total predictability, subject only to default, then government bonds/CDIs, and XTBs, and any directly listed bond are the only securities that are predictable in this way on ASX. Hybrids also are, assuming none of the other risks such as income non-payment or call deferral, or conversion occur.

I think you have to take the position that bond funds, as opposed to direct, are long term positions as are equities – that is because they are dynamic and return in the short term difficult to predict ( interest rates, understanding of underlyings, etc etc) I think yield to maturity in isolation could put investors off a potentially sensible investment in their portfolio, that of a defensive ( not necessarily as a return seeking) investment. And that over time, even with rising interest rates ( as managers reset at higher yields) , the bond component will give you Cash + with defensive attributes. But at Yield to Maturity of 1.3%, people will stay away, just as people didn’t want to take 5 year annuities a year or so ago at 4%. Looks ok now.

Hi Graham, thanks for the XTB mention. You note that one loses the diversification of ETFs when you buy individual bonds, just as you do when you buy individual shares.

But to complete the picture: with individual bonds you also retain one of the most critical features of fixed income investments (for many investors), which is the utter predictability of prospective or future returns if you hold fixed rate bonds to maturity – being the prospective Yield to Maturity that Warren explains fully above.

With any perpetual ETF or fund you automatically lose this predictability because putting maturing bonds (the bond feature that delivers predictability) into a perpetual vehicle results in the loss of both income and capital predictability (as bonds are replaced as the mature).

Its why in the US they see bonds held individually, and bonds in funds/ETFs as different (but related) asset classes because the investment outcomes are so different.

Not the case with equity + equity ETFs, which are both perpetual. So ETFs don’t “mirror” owning bonds as they do for equity, currency, commodities. hence US morphing to maturing ETFs.

Depending on the type of investor – this can actually be fundamental to why bonds and the fund/ETFs are not the same thing. For investors like TD investors who are used to and need total predictability, subject only to default, then government bonds/CDIs, and XTBs, and any directly listed bond are the only securities that are predictable in this way on ASX. Hybrids also are, assuming none of the other risks such as income non-payment or call deferral, or conversion occur.

Valid points, though easy to exaggerate the differences in terms of investment outcomes. I’ve written about this too, here:

https://cuffelinks.com.au/differences-direct-bond-funds/

I have addressed falling ‘risk free’ returns by adopting a barbell risk approach – keeping 80% in cash and physical gold and taking more risk with 20% in Aussie equities. One thing the GFC highlighted was the importance of diversification, especially credit risk. Innovation and disruption of established industries like banking and healthcare have a long way to go providing some excellent risk reward tradeoffs. Given the downward trajectory of $A, the article makes no attempt to maintain or even enhance the wealth of a global citizen who happens to live in Australia