Diversifying Australian Portfolios May Be Easier Than You Think

Diversifying Australian Portfolios May Be Easier Than You Think
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Diversifying Australian Portfolios May Be Easier Than You Think

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.

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Disclosures

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Sovereign securities are generally backed by the issuing government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Diversification does not ensure against loss. Investors should consult their investment professional prior to making an investment decision.