Insights

Fixed interest securities offer investors investment income and portfolio diversification and come in many forms.

ASX-listed Corporate and Bank issued securities offer investors the benefit of higher returns than investments such as Government bonds or bank deposits while providing liquidity liquidity via the ASX platform, however they also carry a higher level of risk.

The income paid will be based on either a fixed or floating rate. Investors should understand the three primary sources of risk which are the credit quality of the issuer, interest rate exposure and the specific structural features of a security.

Main characteristics

• face value – is the price at which the security is issued and the amount payable to the investor at maturity/redemption by the issuer
• distribution/dividend/coupon – the income stream payable to investors either quarterly or semi-annually
• maturity/redemption – the date at which holders will be repaid the face value of the security in cash
• conversion – the date when a preference share or other convertible security will convert into ordinary shares in the issuer (assuming the required conversion conditions are met)

Why invest in fixed interest securities?

Fixed interest securities are generally suited to investors seeking income; however where a security trades at a discount to face value, some capital growth over time can also be expected as the security moves back to its face value at maturity. Conversely, where a security is purchased at price above its face value, only the face value will be repaid at redemption.

Investors seeking portfolio diversification should also consider ASX listed Exchange-traded Government Bonds which, while generally paying lower levels of income than bank and corporate securities, carry a lower level of credit risk. This is because all interest payments and the repayment of the bond's face value are guaranteed by the Government. Government bonds also provide significant portfolio diversification benefits. This is because in times of economic stress where shares and other higher risk asset classes might be expected to fall in price, Government bond prices generally rise.

It is very important to read and clearly understand the security issue terms as the securities in this sector vary greatly. Some general advantages and risks associated with investing in fixed interest securities are outlined below:

General features

• known return profile with distributions / dividends / coupons being either fixed or floating in nature
• yields are higher than government bonds and bank deposits
• returns are more predictable than ordinary share dividends, and in the event that they are not paid on these instruments, companies are generally unable to make payments to ordinary shareholders
• franking is often a component of investor returns for preference shares
• issuers are generally known and trusted names
• ASX listing provides liquidity
• price volatility is generally lower than the underlying ordinary share of the issuer

General risks

• preference share / capital note distributions are are subject to the issuer having sufficient distributable profits to make the payment and in many cases are discretionary
• subordinated note coupon payments may be deferred in certain circumstances
• investors are exposed to interest rate risk and market price risk
• returns to the investor upon conversion or preceding conversion may be affected by movements in the underlying ordinary share price
• in the event that the issuer is wound up, investors may receive less than the security's face value if there are insufficient funds following the repayment of higher ranking creditors
• securities issued by the APRA regulated entities i.e. banks & insurers, may in certain extreme circumstances be converted to equity or written-off resulting in financial loss.

Capital Structure

The size and depth of the listed security market has grown over the past few years, from one which consisted largely of hybrid securities to one which now provides investors with access to a range of instruments across the capital structure (with the exception of covered bonds issued by financial institutions).

Senior Secured Debt

If a company is declared bankrupt or enters liquidation, senior secured debt holders are the first to get their money back and most likely 100% of the principal invested. This is because this class of investor or lender has direct and definable security or legal charge over specific assets of the company e.g. mortgage/lien over real property or other assets.

Senior Unsecured Debt

As we move down the capital structure the probability of receiving all of the money invested decreases in the event of a company's failure. The expected level of recovery will vary depending on the initial financial strength of the company but senior unsecured creditors have the first access to the proceeds in the event of liquidation (behind any secured lenders). Most corporate debt is issued on an unsecured basis.

Subordinated Debt

This is another notch down in the capital structure and while still debt with a defined maturity date and interest payment obligations, in the event of wind up, the interests of the subordinated-debt holders will rank behind the senior debt holders (both secured and unsecured). Companies also issue subordinated debt as in many instances rating agencies look favourably on these instruments and provide them with "equity credit".

Capital Notes / Preference Shares

Capital Notes and Preference Shares, often referred to as Hybrids, pay dividends which rank ahead of the payment to ordinary shareholders. These securities follow the sequential nature of risk, just as subordinated debt is subordinate to other forms of debt; hybrids are subordinate to all forms of debt, but generally rank ahead of ordinary equity in the event of a wind-up.

Ordinary Equity

Finally, ordinary equity sits at the bottom of the capital structure. If things turn sour, this is the first call on capital or funding to wear the pain. This arises from the fact that there is no obligation to repay equity or provide any income stream, so companies are breaking no agreements or laws by losing shareholder value or not paying dividends. There are risks associated with moving down the capital structure from senior secured debt to ordinary equity which include:

• a reduction in the security of cashflows
• no recourse against an issuer should payments not be made or capital is put at risk;
• liquidity in the instrument may decrease particularly in times of financial stress
• ranking or priority of claim in the event of the issuer being wound up

Types of listed fixed interest securities

While the major details of fixed interest securities have been outlined above including, the features and risks of investing in this asset class, it is important to understand the differences between the various types of securities on issue.

Download the PDF to learn about the types of securities available, including:

• debt securities
• convertible preference shares
• convertible notes
• reset preference shares
• income securities
• step-up preference shares

This document also has more information on the risks and factors impacting fixed interest securities.

Key terms and their meanings

There are a number of terms used in the fixed interest market which may be unfamiliar to many investors. These are explained below:

• Current price – most recent security price as at the date of publication
• Price target – may be set at a discount or premium to the Morgans assessed fair value depending on a variety of factors
• Cash running yield – is calculated as the cash distribution payable to holders (based on the security’s issue margin plus the one year swap rate) divided by the last traded price of the security
• Gross running yield – is calculated as the cash distribution payable to holders (based on the security’s issue margin plus the one year swap rate) plus franking credits (if applicable) divided by the last traded price of the security
• Yield to maturity/call (YTM/YTC) – investor's expected return having paid the published current price and assuming all distribution payments are made through to conversion. In addition, the calculation assumes investors realise the face value of the security and fully utilise any franking benefits. Income forecast for the calculation of the YTM/YTC is calculated using the interest rate swap curve
• Trading margin – the YTM/YTC minus the relevant swap rate and shows the return premium required by investors to purchase the security rather than investing in bank bills. The relevant swap rate is determined by looking at the maturity/conversion date of the security and matching that to a comparable level along the interest rate swap curve. i.e. if a security has a YTM/YTC of 7.00% and four years to maturity, this would be benchmarked to the four year swap rate (e.g. 4.00%); subtracting this from the YTM/YTC gives a trading margin of 3.00%.
• Accrued distribution – the income accrued to date in the current dividend or distribution period
• Swap rate – this is a benchmark yield that is determined on a daily basis by a panel of banks across a range of terms and provides a benchmark from which a range of financial instruments and transactions are priced

The Australian Bureau of Statistics (ABS) has reported that seasonally adjusted retail sales were $36.5 billion in November 2023, the highest monthly sales number ever reported. This was 2.0% higher than in October 2023 and 2.2% higher than in November 2022. Due to the timing of Black Friday Cyber Monday (BFCM) and the lead-in to Christmas, November is seasonally the biggest sales month of the year. Retailers started their BFCM discounts early in 2023 and ran them for longer, offering even bigger deals than we’ve seen in previous sales periods. This means it is likely some discretionary expenditure was deferred from October to November. We also anticipate that, when they are released on 30 January, the December 2023 sales figures will show a pull forward of sales into November from that month. The strongest performers were Household Goods (especially Electricals and Electronics) and Department Stores.
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November 2023 sales up +2.0% month-on-month
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Retail sales in November 2023 were up 2.0% on a weak October (which itself saw sales down 0.4% on the previous month). BFCM was clearly a success, and so much so that it appears consumers deferred discretionary expenditure they might otherwise have made in October.

Online sales penetration spiked in November, up to 12.7% from an average of 10.6% for the 10 months of 2023 beforehand and 10 bps higher than the 12.6% reported in November 2022. Online sales totalled $4.92 billion, also a new monthly record.

Electrical and Electronic Goods (within the Household Goods category) were the clear standout, with sales in November 14.4% above October. This may be good news for JB Hi-Fi (JBH). Furniture (+9.7%) was also strong, which could be positive for Adairs (ADH), Nick Scali (NCK) and Temple & Webster (TPW).

All major categories of retail sales were in growth on a month-on-month basis, along with almost all sub-categories, with the exception of Hardware (down 0.9%), Takeaway Food (down 0.2%), and Newspapers and Books (down 0.2%).

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November 2023 sales up +2.2% year-on-year

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Clothing and Footwear sales were flat year-on-year (-0.1% to be precise), but all other major categories reported sales that were higher than in November 2022. Eating Out (+4.4%) was up the most, reflecting the effects of food inflation.

Pharmaceuticals and Toiletries were up 8.6% and Electrical and Electronic Goods were up 3.9%. Moving in the other direction were Newspapers and Books (down 10.8% year-on-year) and Footwear (down 3.7%).

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When you start a family, your focus is on financial stability – wealth creation and wealth protection. The big changes in life – a young family, a home, a change at work, windfalls – provide the perfect opportunity to review your financial situation.

Debt management

When you are in your thirties and forties, debt can play an important role in helping you achieve your lifestyle and financial goals. It must, however, be managed effectively as some debt structures are more efficient than others.

Efficient Debt

Any debt used to purchase assets that generate an income can result in the interest costs being tax deductible. Where these assets also grow in value, this form of debt is considered to be efficient.

Inefficient Debt

Loans taken out to purchase non-income producing assets or services (for example a car or holiday) do not qualify for a tax deduction in relation to the interest cost. This form of debt is considered to be inefficient from a wealth creation perspective and is often a drain on accelerating your long-term wealth accumulation if not managed properly.

Wherever possible you should try to accelerate the repayment of inefficient debt, and consider replacing it with more efficient debt structures that can be used to create wealth, tax effectively.

Ways to reduce inefficient debt

• manage and understand your cashflow to ensure you are making the maximum possible loan repayments
• choose the loan that has the best structure for you. A lower interest rate does not necessarily mean that you will pay less interest over the life of your loan. Often it is the flexibility and the features offered in a loan that will determine how well various strategies can be put in place to reduce the outstanding loan as quickly as possible (and hence reduce the amount of interest payable)
• making use of the interest free component of your credit card for everyday expenses allows your money to reduce your average daily loan balance and as a result your interest bill and the loan term

Investing

Borrowing to Invest

With plenty of years left to retirement, many thirty and forty-something investors borrow funds to build their wealth. The long term view on this strategy allows them to increase their investment portfolio and manage their tax deductible debt in an effective way. Be very mindful, however, that borrowing can also magnify capital losses. Any borrowing strategy should therefore be approached with caution. Understanding the risks involved is very important.

Margin Lending

A margin loan lets you borrow money to invest in shares and other financial products, using existing investments as security. Commonly, borrowing limits are set to a certain value or percent depending on the type of asset (eg shares) you are buying, with the difference made up from your own cash or existing investments. This difference is referred to as the 'margin' - hence the name 'margin lending'.

Property

Property investors can choose to invest directly into a property, or via a listed or unlisted property trust. Your Morgans adviser will be able to help select an appropriate strategy for you, depending on your personal circumstances and investment objectives.

Shares

Regardless of whether you borrow to invest or not, it is still a good time to think about investing in shares, either directly via the sharemarket, an ETF, or via an unlisted managed fund. Most share prices are at a reasonable value. Your adviser will be able to help select the most appropriate method of investing to suit you.

Franking credits

Companies paying Australian tax keep a record of the amount paid in a franking account. When the company declares a dividend it is able to attach all or some of that franking account to the dividend as a franking credit.

Most companies listed on the Australian Stock Exchange pay dividends to shareholders that include franking credits. The franking credit and resulting tax benefit available from the dividends means the actual return from that particular stock needs to be "grossed up" to reflect its true value.

The following table highlights the grossed-up effect of various dividend yields, as well as the equivalent after tax yield based on flat 15%, 32.5% and 45% tax rates.

Fixed interest

Portfolio diversification is an essential element to a successful investment strategy. This applies equally across a portfolio and within asset sectors.

When investing in fixed interest, a spread of investment helps provide both capital certainty and regular income. As part of your planning you will most likely require some component of liquidity i.e. ready access to cash, some longer term investments as well as attractive levels of regular income.

Cash management accounts

Liquidity within a portfolio can be achieved by maintaining an “at-call” cash account which is linked to your investment account for easy settlement. You can also have your dividend payments credited directly back to the account and make regular payments from it.

Term deposits

A term deposit is a deposit held at a financial institution that has a fixed term. Term deposits continue to remain attractive to investors looking to maintain a balanced portfolio with exposure to low risk non-equity investments.

You can use a term deposit to enhance the returns on surplus cash balances or to build a dedicated income portfolio.

Government and corporate bonds

Government and corporate bonds also help reduce portfolio risk while providing a stable income.

The yields on government bonds will generally be lower than most other interest rate investments but provide absolute security when held to maturity.

Hybrid investments

Hybrid investments generally deliver higher levels of income, paid quarterly, along with benefits of franking. You should discuss with your adviser which securities will suit your risk profile and meet your income needs.

Other investment ideas

If you stick to the basics of investing you will have a much better chance of getting through any period of high volatility and uncertainty.

It's not all about market timing and stock selection as they only play minor roles in the performance of your investment portfolio. It is about asset allocation, active reviews, professional advice, and sticking to your long term strategy.

Wealth Protection

Greater financial responsibility – such as mortgages, marriage, and children – means the impact of illness, injury or death is greater.

Protecting your family and assets through insurance has more of a sense of urgency, especially when the family is reliant on your income.

Things you need to consider at this stage in life are:

• the elimination of debt (mortgage, car loans, or even credit cards)
• provision for daily expenses for you and your family in the event you're unable to provide income
• education expenses
• medical costs

Due to the vast range of products on the market, in order to get the right features for your situation, you need specialist advice.

Some things you need to consider:

• the level of insurance
• ownership structures
• funding arrangements

Protecting your wealth in this stage of life is more complex so it is crucial you speak with a financial adviser before committing to a decision.

Your options

Life, Trauma and Total and Permanent Disablement (TPD) protection can provide a lump sum payment to cover debts and secure your financial future or that of your loved ones. Trauma insurance will provide a lump sum in the event you're diagnosed with a serious illness, while TPD protection covers you in the event you’re permanently unable to work due to injury.

Income Protection will help continue to meet your financial commitments and daily living expenses.

Business Expense Insurance should be considered if you have a business or are self employed and injury, illness or premature death would cause financial problems. Consider – if you were unable to meet expenses such as electricity, rent, telephones and staff salaries would your business survive?

Superannuation

This is the time to really get serious about your superannuation savings. Laying the groundwork for retirement now will help you reap the rewards when you finally give up work. As they say "failing to plan means planning to fail".

Salary sacrifice

A common strategy for employees is to forego a portion of salary in lieu of increased contributions to superannuation. Contributing pre-tax salary into super not only reduces your income tax, it increases your savings within super. Over the long term, these additional savings can make a significant difference to your account balance for retirement.

Regular savings plan

Don't forget the benefits of "dollar cost averaging" via a regular savings plan to help save for future goals such as your children's education costs, or home renovations, for example. Your money will buy more shares or unties when prices are low, and as prices eventually rise your investment will also grow proportionately.

ESG (Environmental, Social and Governance), Socially Responsible Investing, Greenwashing and Corporate Responsibility are all becoming common terms and areas to consider for both Australian investors and Corporates.

Although the use of the term ESG has only occurred within the last 20 years, sustainability has been considered by investors as far back as the 1960’s with the use of socially responsible investing.

Socially Responsible Investing or ESG Investing involves socially conscious investors such as Not-For-Profits using ESG criteria to screen potential investments and assess whether they fit their values, mission or sustainability mandate.

With the announcement of new climate reporting requirements, the focus has shifted from Corporates voluntarily considering their ESG and sustainability positions, to now being faced with mandated reporting requirements, audited sustainability reports and potential director penalties for non-compliance.

Australian companies will need to be carefully considering their ESG strategy, climate related risks and plans, with stakeholders including investors placing more interest in companies that have a sustainable, climate aware businesses.

The recent 2023 ASX Investor Study found that 31% of investors are ESG conscious, with those investors focusing on companies that make a positive impact and avoiding companies that create social and environmental harm.  This view was more prevalent in younger generation investors (18 to 25 years) and those in wealth accumulation phase aged between 25 to 49 years.

Although the Environment or ‘E’ in ESG has been a high focus, it is now becoming common for companies to be closely considering their social impact and governance strategies as these have a wide impact across all stakeholders including investors, suppliers, customers and employees.

Morgans has a specialist Not-For-Profit and ESG team that can assist you on all your ESG and negative screening questions. Get in touch with your Morgans adviser to find out more.

The landscape of consumer discretionary stocks is ever evolving, shaped by economic indicators, company performances, and broader market trends. As we wrap up another year, it's crucial to revisit our projections and recommendations based on the latest data. Following the recent Annual General Meetings (AGM) season and shifts in foreign exchange (FX) rates, we've conducted a comprehensive review of our earnings estimates and target prices for companies within the consumer discretionary sector.

Updated Earnings Estimates

On a median basis, our Net Profit After Tax (NPAT) forecasts have been adjusted downwards by 1% for both FY24 and FY25. This adjustment primarily reflects our expectations for lower gross margins and increased operating costs across the board. Despite these reductions, our revised FY24 estimates stand 3% above the Visible Alpha consensus, indicating a slightly more optimistic view compared to the broader market expectations.

Strategic Recommendation Changes

The Reject Shop (ASX:TRS): We've upgraded our recommendation from Hold to Add. This decision reflects our reassessment of the company's growth prospects and its ability to navigate the current market dynamics.

Key Picks in Consumer Discretionary

Lovisa (ASX:LOV): Renowned for its fast-fashion jewelry offerings, Lovisa continues to exhibit robust growth potential, underpinned by aggressive international expansion and resilient consumer demand.

Super Retail Group (ASX:SUL): As a leading retailer catering to outdoor, sports, and auto enthusiasts, Super Retail Group has demonstrated commendable resilience and growth, making it one of our top picks in the sector.

Conclusion

As we navigate through fluctuating market conditions, our updated models reflect a cautious yet opportunistic stance on the consumer discretionary sector. The adjustments to our earnings forecasts and the strategic changes in our stock recommendations aim to capture the evolving landscape and identify opportunities for investors. Lovisa and Super Retail Group, with their distinct market positions and growth strategies, exemplify the potential for outperformance in this dynamic sector.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Contact your Morgans adviser to access the full research note or begin your journey with Morgans today to view the exclusive coverage.

Following the Federal Reserve's latest meeting, Morgan's Chief Economist, Michael Knox, provides an update on the Summary of Economic Projections, stating that rates will continue to fall until 2027.

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