Opportunity amidst uncertainty: Investment alternatives
WITH the upcoming maturity of the GOJ May 2011 bond, individuals and institutions will be awash with cash in coming months actively seeking alternative investments. Back in 2001 when these securities were purchased, investors enjoyed yields as high as 12 per cent and above on plain vanilla B-rated bonds.
Investors in these bonds will be hardpressed to find the same yields on similar risk levels. Interest rates in Jamaica and across the globe have declined significantly. Bill Gross of PIMCO (manager of the world’s largest mutual fund) maintains that we are in a “new normal of lower returns and volatility”. What does this “new normal” mean for your investment strategy?
The fundamental change in the global financial landscape that has taken place over the last few years has brought our focus to one underlying characteristic: credit quality. While there are many different types of risks inherent in all financial instruments, chief among them is the risk that the issuer or writer of an instrument will default on its obligation. We saw large corporate entities and governments brought to their knees as a result of the market’s doubts about their ability to honour their obligations. The story of credit quality is told by the financial statements — corporate and sovereign entity alike. Investment managers and rating agencies are the most common “assessors” of credit quality.
How can we get good returns on instruments of high credit quality?
Large and systemically important investment grade financial institutions have proved to be a great source
of value throughout the recession. Rabobank, also known as the “world’s safest bank” (rated AAA by S&P) as well as Barclays PLC (the world’s second largest bank rated A- by S&P) are great examples of sound corporate entities which can generate yields of up to seven per cent. A strong capital base, sufficient levels of liquidity and a high quality asset portfolio were the main factors underpinning the high credit ratings of these entities. In turn, their debt presents an attractive fixed income opportunity to the liquid investor who wants to preserve and grow his principal.
Previous Sterling Reports also commented on Municipal Bonds — which have been a much debated topic in the markets and the source of much doom and gloom. However, we highlighted the importance of fundamental and careful analysis. With this in mind, we took a closer look at the State of California, the world’s eighth largest economy, rated A- by S&P. The negative market sentiment on Municipal Bonds successfully clouded the economic value underlying the instruments. California’s investment grade credit rating was primarily a result of the State’s relatively conservative debt burden, the broad size and depth of the economy and the Government’s demonstrated willingness to take the necessary steps towards greater revenue generation. The State of California just reported that tax revenues are US$2 billion ahead of projections, further highlighting the State’s ability to meet its debt obligations. All these bonds are now trading at sizable premiums, indicative of the increase in demand for this high quality paper.
Structured notes with call options (ie provisions for the issuer of a note to redeem the principal), perpetual maturities (ie notes that have no fixed maturity date), and fixed to floating interest rates are also excellent ways to increase the return on your assets without increasing the credit risk. The premium return offered on these instruments compensates the investor for relatively higher levels of interest rate risk and reinvestment risk. However, these risks are far more easily managed by an investment manager and also do not jeopardise the value of your original principal. Looking at fixed income notes with slightly different structures can produce higher returns for a given unit of credit risk.
Marian Ross is a business development officer at Sterling Asset Management. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm