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Bond investing and financial advisers

Massey University's Michael Naylor responds to adviser Brent Sheather's comments about bond investing.

Tuesday, November 11th 2014, 5:59AM

Brent Sheather wrote an interesting article in the NZ Herald on Thursday. As usual it was insightful and provocative and made some useful points.

One of Brent’s major arguments is that in the bond part of their portfolio NZ investors should stick with low risk bonds like those issued by government, SOEs or city councils, and should stay away from the higher risk types, like finance company debentures. He criticises financial advisers who persist in recommending finance company debentures. His major reasoning for focusing on low-risk bond is the classic portfolio theory that the role of bonds is to anchor the low risk end of an investor’s portfolio and act as a counter-weight to riskier elements, as bonds are seen as moving counter-cyclically to shares. Junk-debentures do no fulfil that role, as they tend to co-move with shares during market stress.

Brent’s argument is fine at an AFA (non-complex) level but current portfolio theory argues things are not that simple. Current theory argues that junk bonds should be treated as similar to shares and, as such, have a valid part in a diversified portfolio. They should be appraised based on their return/risk characteristics and regarded as analogous to shares, with debentures from large finance companies being bluer chip, and smaller ones being clearly junk. Any counter-cyclical benefits should be ignored. Note that the put-like return characteristics of debentures would argue for higher returns than comparative equities. The research trick is then being able to differentiate traditional bonds from equity-like junk bonds on something other than a B+ rating.

The key words here were ‘diversified portfolio’, so they would be the 30th security, not the 2nd. My major problem with debentures prior to the naughties crisis is not that they were used but that finance company debentures were under-priced – given the lack of dividends and risk level, the riskier ones should have being returning at least 16%. That would have compensated investors for the coming bankruptcy and given investors a clear idea of risk level. At that return, I’m sure Brent could see a role for a few being included at the riskier end of the portfolio.  Of course, if debentures had paid that much, investors would have sensibly stayed away, so they were instead priced at 3 or 4% above safer bonds, and thus fooled investors into thinking they were safe.

Brent also argues that many AFAs offer poor advice on bonds, with too many seeing junk debentures as representing the low-risk end of the portfolio. In this criticism he is generalising too much. At the well qualified degree or CFP end of the AFA scale the vast majority of advisers would deserveably resent the way he attacks all AFAs and then only cites a few bad cases. My feel is that most AFAs who are also CFPs understand bonds in more depth than he gives them credit for.  Even at this end, however, most would only have got as far as understanding the need to match bond duration (rather than maturity) to a client’s portfolio, with maybe a hazy idea of the importance of convexity.  As I have noted before on Good Returns, this enables advisers to match their clients to safe bonds or bond portfolios, it doesn’t enable them to construct a bond portfolio or model bond risk under stress scenarios.

At the lower end of AFAs, however, my impression is that advice is becoming far worse than even Brent alleges. Aiming for a CFP has stopped becoming de facto – and the unfortunate impact of regulation has meant that many new advisers, especially those bank-based, are settling for level 5 certification. These advisers are so far out of their depth discussing bonds that it’s scary. Authorisation has given these advisers the idea that they can advise on bonds, when they don’t even know the depths of what they don’t know. These AFAs should certainly stick to saying – ‘put x % in our provider’s kiwisaver and x% in our provider’s fixed deposit.’  Their main focus should be on client behaviour and creating a savings/ investment plan, via low-cost funds.

Brent is, of course, correct that AFAs who charge solely via a commission will have an issue with recommending low-return bonds, as once fees and inflation is removed clients will often experience negative returns. This is a good reason for advisers charging a set fee for advice, and reducing other fees as low as possible, as then advice can focus on which fund is lowest cost. As noted in other industry discussions, it would help if the FMA required all NZ funds and platforms to release all fees, including embedded fees.

 

You can read Brent's column here.

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