Building the 6% yield dream team in corporate bonds

6% yield - that's the magic number many Livewire readers said they need to achieve their desired lifestyle. What stood out to me was that many were heavily reliant on equities to do that heavy lifting. However, fixed income’s modest risk profile allows for an efficient return per unit of risk.

The team at Income Asset Management has taken on the challenge of putting together a hypothetical portfolio of fixed-income assets that could deliver on the income requirement and offer some diversification. We're calling it The 6% Yield Dream Team or as Ted Lasso puts it ‘’I do love a locker room. It smells like potential.”

In this article for Livewire's 2021 Income Series, I'll explain why diversification is essential to make fixed income work in a portfolio and talk through the ten inclusions in our hypothetical portfolio of corporate bonds.

Diversification is the key

Whether it be in an equity portfolio, property or fixed income, ensuring risk is spread across a range of individual investments within an asset class helps to prevent large negative capital impacts from unforeseen events.

Fixed Income assets, including bonds, inflation-linked bonds and floating-rate notes, allow investors to diversify in four ways:

1. Credit or issuer risk: The risk the borrower will default.
2. Interest rate exposure or duration risk: The term or length of the credit exposure.
3. Liquidity: How easy it is to get your capital back.
4. Currency: The currency in which the credit is issued.

Fixed income investments also allow investors to manage cashflows (asset/liability match) through interest payments (coupons). Staggering maturity profiles of fixed-income investments can help to smooth out lumpier capital redemptions. There are few asset classes that can mitigate drawdown risk while providing income/return potential and liquidity.

To achieve a prudent level of diversification it is important investors have access to a wide range of fixed-income securities. 

Choice; or a diverse view of fixed income markets is important to assess the value of securities against a broader backdrop of investment opportunities.

IAM Capital Markets is market agnostic. We assess fixed income securities trading in all currencies, through listed exchanges and investment grade and high yield markets globally. 

This approach ensures investors can adequately assess relative value, diversify portfolios and access opportunities through different markets.

Drafting a diversified portfolio targeting a “high yield” return of 6% p.a

Let's get to our high-yield portfolio and run through the different bonds we have selected.

The portfolio includes 10 equally weighted investments spanning ASX-listed, AUD and USD issues trading in over-the-counter (OTC) markets. The portfolio includes investment grade, sub-investment grade and issues that have not been rated by an agency.

IAM Capital Markets provides internal Credit Opinions from our Credit Strategy team and independent research reports from our research partner BondAdviser for all issues included in the portfolio. 

When putting together the portfolio these were the steps we followed.

1. Range of credit ratings - we chose attackers (lower-rated) and defenders (higher rated) to ensure that the portfolio can score and defend regularly.
2. Range of industries - we chose a midfield that consists of various industries, from airports, banks, mining, telecommunications, and other financial services. Diversification of industries helps to eliminate idiosyncratic risk from a portfolio and lower a portfolio’s variance. If a midfield is doing their job, the engine room is working.
3. Range of maturities - we chose a mixture of short and long-term bonds. Short-term bonds have less interest rate sensitivity and so act like goalkeepers for capital preservation. Long-term bonds have more interest rate sensitivity, and thus can be more volatile from a capital perspective. We call these the super substitutes!
4. Currency - just like having a good manager and coach, you need multiple currencies, including AUD and USD respectively. Both react differently given their volatility relative to the market (or Beta). For instance, the AUD is more sensitive to the terms of trade (TOT) and commodity prices than the USD respectively. However, each currency is just as important to the overall team and desired portfolio outcome.

The 6% Yield Dream Team

Putting theory into practice the table below shows how we have set about putting together a portfolio of corporate bonds aiming to hit the 6% yield target. Beneath the table we've provided brief commentary on each of the bonds and why they were selected.

Click on the image to enlarge

*IAM Capital Markets provides internal Credit Opinions from our Credit Strategy team and independent research reports from our research partner BondAdviser for all issues included in the portfolio.

Latitude Group HLD - 5.7% (Unrated)
Solid fintech provider that is better placed than other businesses to deal with the implementation of stricter regulation given the longer track record. The structure of Latitude notes is very strong. Distributions are deferrable (but cumulative), there is a dividend/buyback stopper, there is a change of control 5% step-up, and if Latitude notes are not called (at first call) margin increases to 12.75-13%. Not many domestic subordinated financials offer a coupon of BBSW3M+4.75%.

Capital Alliance AU Pty Ltd - 10.00% (Unrated)
High-yield senior secured property credit that has three operational hotels and two assets under construction. Covenant package includes a gearing LVR, asset LVR, minimum total tangible asset (TTA) clause and interest service reserve account (ISRA). A coupon of 10% for a substantial asset-lend looks appealing versus other high-yield names.

Jervois Mining USA - 10.55% (Unrated)
High-yield credit uniquely placed to the battery metal thematic (nickel and cobalt). Recent underwritten equity raising has significantly de-risked the credit and raising additional liquidity over the construction period. The first production is due in late 2022. A coupon of 12.5% looks appealing versus broader USD high-yield universe and other metals and mining names.

Coburn Resources PTY LTD - 10.735% (Unrated)
High-yield credit is uniquely placed to the mineral sands thematic. Mineral sands can be used in a range of everyday household products. All major construction contracts have been awarded and 100% of offtakes have been secured. The first production is due in late 2022. A coupon of 12% looks appealing versus broader USD high-yield universe and other metals and mining names.

Other names in the portfolio which have an external rating include:

National Australia Bank - 4.35%
Solid major bank Tier 1 (Hybrid) security offering a 4.95% coupon.

Sydney Airport Finance - 3.5%
Number one airport across the country. Protects investors against rising inflation, with a coupon of CPI+3.12%.

Liberty Financial Pty Ltd - 3.13%
Solid financial services provider with a coupon of BBSW3M+3.75%.

Pacific National Finance - 3.3%
Solid haulage company, with increasing revenue base from intermodal (non-coal related activities). Best investment-grade bond on a risk-return basis.

NBN Co Ltd - 2.67%
An essential piece of infrastructure for the Australian economy that has strong bipartisan support from both major political parties.

Emeco Pty Ltd - 5.75%
Solid high-yield mining services provider that is benefiting from high commodity prices. Potential for an upgrade from B+.

Learn more about Income Asset Management

IAM offers sophisticated investors direct access to over 700 corporate bonds. If you’re interested in learning more about how bonds play a role in your portfolio please visit our website for more information.

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