Understanding Fixed Interest Securities

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