Diversifying Australian Portfolios May Be Easier Than You Think
To meet the growing need for income and diversification, especially for retirement portfolios, there is an alternative to bank hybrids and equities that seems to be overlooked
At the annual Portfolio Construction Forum in Sydney this week, the discussion in the presentations, on the panels and in the corridors was lively, as usual. One of my key takeaways was that Australian investors’ portfolios remain excessively risk-on and highly concentrated in Australian banks – whether equities, hybrids or term deposits – and in residential property, through both direct investment loans and exposure to Australian banks’ balance sheets.
Illustrating this point, when Commonwealth Bank launched a new retail hybrid transaction on the day of the conference, the hot topic was whether the securities were priced a few basis points too “cheap” or too expensive. The pricing debate missed the real point: Australian banks are now required to pay up significantly – as much as 240 basis points to 400 basis points more than in their previous hybrid deals – because investors with highly concentrated portfolios have become more discerning and are requiring higher yields.
The fact that Australian retail investors in new hybrid securities are finally receiving decent compensation for the risk is great, but what does it mean for the banks themselves? It means their cost of capital has gone up much faster than any of them would have imagined just a few short months ago, and in a world where all banks are required to hold more capital, returns on equity will be squeezed even further. So although yields on hybrids are tempting, increasing exposure to Australian banks now may not be a sound, long-term investment strategy.
Where, then, should investors look for yield? Government bonds are generally low-risk – but also low-yielding. With the Reserve Bank of Australia inclined to cut rather than raise rates, Australian yields could go even lower.
To meet the growing need for income and diversification, especially for retirement portfolios, there is an alternative that seems to be overlooked: high quality corporate bonds. They can provide attractive, low-risk income and potentially offer good value right now: Prices have fallen significantly amid the oil price plunge and overall market volatility, despite these bonds’ generally low default risk.
The global investment grade credit market offers yields well above government bonds, the opportunity to diversify and in the current environment, compelling opportunities to earn a potentially healthy return with much less mark-to-market volatility than Australian bank hybrids and equities.
Sometimes, the solution is easier than you think.