To fund corporate activities (amongst other things) companies issue bonds and hybrid securities to investors. A majority of corporate debt is routinely issued to institutional investors who have access to larger amounts of funds than retail buyers.
For the best part of the last decade, interest rates have rewarded self-managed super funds (SMSFs) with high rates of return. However, record-low interest rates are forcing more investors to look outside cash accounts. The hybrid and listed debt rates on offer from big corporates is significantly higher than what retail investors can receive from term deposits and cash accounts – at a greater level of risk, of course.
We've already seen the S&P/ASX200 (ASX: XJO) (^AXJO) push higher as more investors went in search of big dividend yields, but many may have overlooked debt markets.
However that could be about to change.
Hybrid fund manager at Elstree, Campbell Dawson, was quoted in The Australian Financial Review as saying money has already begun to flow from SMSFs into other assets: "Already we have seen some leakage into other assets, but given that SMSFs do one of two things when they invest (in other words they buy AUD equities or AUD property) we can see a degree of overvaluation as a portion of the $150 billion cash hoard hits those asset markets."
Following the final changes to capital requirements issued by APRA in 2012, financial institutions issued smaller amounts of hybrid securities, as they sought to adjust to the new requirements set down by the regulator. However, in the past year Westpac Banking Corp (ASX: WBC), Australia and New Zealand Banking Group (ASX: ANZ) and National Australia Bank Ltd. (ASX: NAB) issued approximately $3.75 billion of securities. Each were met with significant demand from investors.
Increasing demand from retail investors and the willingness of companies to issue securities at low rates of interest has prompted analysts to believe that the big banks, including Commonwealth Bank of Australia (ASX: CBA) and Bendigo and Adelaide Bank Limited (ASX: BEN) – as well as a number of corporations – will issue large amounts of fixed income securities in 2014. Bell Potter's Damien Williamson is expecting the major banks to replace around $5 billion of maturing debt – according to the AFR.
Foolish takeaway
Bond prices move in the opposite direction to interest rates, therefore its best to buy when interest rates peak. As an example in 2011, interest rates were expected to fall and ANZ issued notes paying around 8% per annum. Fast forward to 2013 – when interest rates fell to record lows – NAB offered its $1.7 billion of hybrids at a rate around 5.79%.
In addition to interest rate risk, trigger events (such as profit writedowns), liquidity and subordinated risks can have a significant impact on the value of issued debt. For investors looking to enter the market it's important to establish an appropriate level of exposure to bonds, property, cash and equities to minimise downside risks.
As an alternative, at current interest rates, investors could find significantly undervalued high yielding (5%+) stocks with plenty of growth potential while they wait for interest rates to rise.
